80.2K

Verified Solution

Link Copied!

Question 3 XYZ is an unlevered firm, and its expected earnings before interest and taxes is $1.2 million each year. Its tax rate is 40%, and current market value is $10 million. Its stock has a beta of 1, and the risk free rate is 9%. Equity market risk premium (Market return-Rf) is 6%. The firm is thinking about adding more debt in its capital structure. Debt would be issued and used to buy back stock, so that the size of the firm would not change. The default free interest rate on debt is 12%, and won't be higher than 15% for the firm. Since interest expense is tax deductible, the value of the firm will increase as debt is added to the capital structure, but there would be an offset in the form of the rising cost of bankruptcy. The firm's analysts have estimated that the present value of any bankruptcy cost is $5 million and the probability of bankruptcy will increase with leverage according to the following schedule: Value of debt Probability of failure Choice Value of debt (a) (b) (c) (d) (e) (f) (g) 1,000,000 2,000,000 3,000,000 4,000,000 5,000,000 6,000,000 7,000,000 bankruptcy prob. 0 5% 8% 12% 30% 50% 70% REQUIRED Q3.1 What is XYZ's cost of equity and WACC when it is unlevered? [10 Marks] Q3.2 What are the direct and indirect bankruptcy costs? [10 Marks] Q3.3 The firm is thinking about choosing the debt level from (a) to (g) (that is, choose the value of debt which equals to 1 million, or 2 million, or 3 million, ...., or 7 million). Use the adjusted present value approach to analyse what is the optimal level of debt to be used by the firm. [30 Marks] Q3.4 Suppose that the firm chooses the optimal level of debt as suggested in Q3.3, please calculate the firm value under the adjusted present value approach. [20 Marks] Q3.5 What is the effective tax rate and what's its relation with the stated tax rate? If the firm's earnings before interest and taxes (EBIT) is 1.5 million and the interest expense is 1.05 million, what is the effective tax rate? If the firm's EBIT is 0.5 million and the interest expense is 1.05 million, what is the effective tax rate? [30 Marks]

Answer & Explanation Solved by verified expert

See Answer