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Problem #1: A firm with a normalized pretax income of $40 million, a 25% tax rate, and a Total Debt/Total Capital ratio of 30%, decides to undertake a capital expansion financed by new debt. The new level of debt will raise the Total Debt/Total Capital ratio to 40% (5 percentage points above its industry average). As a result, the firm's credit rating is downgraded by a full level (say for example, from A to B) despite being secured by specific assets. This credit downgrade raises the firm's Weighted Average Cost of Capital (aka Required Rate of Return) from 10% to 11.5% a) What is the value of the firm prior to the downgraded credit rating? Value of the firm prior to the Downgraded Credit Rating = [Pretax income * (1-tax rate)] / Weighted Average Cost of Capital before credit rating downgrade Value of the firm prior to the Downgraded Credit Rating = [$40 million * (1-0.25)] / 0.10 = ($40 million * 0.75) / 0.10 = $30 million / 0.10 = $300 million b) Assuming the firm's capital expansion program will lead to a 20% increase in normalized pretax income, what is the firm's value in the aftermath of the credit downgrade? Pretax Income after credit rating downgrade = Pretax income before downgrade * (1+rate of increase) = $40 million * (1+0.20) = $40 million * 1.20 = $48 million Firms Value in the aftermath of the credit downgrade = [$48 million * (1-0.25)] / 0.115 = ($48 million * 0.75) / 0.115 = $36 million / 0.115 = $313.04 million Problem #2: How would your answer to Problem #1 change if the debt was unsecured? Specifically, what might the credit rating be under an unsecured format and how would this affect the value of the firm? Explain or provide your reasoning. Leaving the debt unsecured would lead to an increase in WACC due the increase risk to lenders, which could potentially increase the expected return by the lenders of the funds. This could lead to a decline in the value of the firm since WACC will increase. The denominator will increase leading to fall in the value of firm in case of capital expansion causing the credit rating of a company to fall (say for example, from A to B). Problem #3: How would your answers to Problems #1 and #2 be affected by the percentage of insider ownership of equity and what life-cycle stage the firm is in? Explain or provide your reasoning.

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