Question

Problem #1: A firm with a normalized pretax income of $40 million, 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% 1. What is the value of the firm prior to the downgraded credit rating? 2. 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? 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. 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.

Answer 1

1. Value of firm before expansion= Earnings after tax/ WACC

= $40 million*(1-.25)/ 10% = $ 300 million

2. Value of firm after down credit rating= $40 million*1.2*.75/11.5% = $313.04 million

3. if the debt is unsecured, it would usually lead to a further increase in weighted average cost of capital due to increased risk to the lenders thereby increasing the expected return by the lenders or providers of funds.

Impliedly, it would lead to fall in the value of firm since wacc will increase i.e the denominator will increase leading to fall in the value of firm in case of capital expansion.

thus, the credit rating will also consequently fall.

3. earlier , the debt was 30% of the total capital thereby meaning that 70% of the capital is equity but after capital expansion by way of debt, the equity share will fall dwon to 60%(since debt is 40% of the total capital).