Question

Suppose a firm has invested $500,000 in plant, equipment and
working capital. The investment

generates EBIT of $120,000 in perpetuity. Annual depreciation
charges exactly equal capital

expenditures and the firm pays all of its earnings as dividends.
The firm’s sales do not grow, but remain

stable over time. The firm is deciding on its capital structure by
considering all debt levels of 0%, 10%,

20%, 30%, 40% and 50% of current total assets ($500,000). Tax rate
is 50%. Cost of debt and equity at

different debt levels are as follows:

Debt Level | 0% | 10% | 20% | 30% | 40% | 50% |

Cost of Debt | 8.00% | 8.25% | 8.75% | 9.75% | 11.00% | 12.50% |

Cost of Equity | 12.00% | 12.50% | 13.00% | 13.50% | 14.50% | 16.00% |

a. Find the net income at different debt levels.

b. Find market value of equity and total firm at different debt levels.

c. Find the value of WACC at different debt levels.

d. Graph debt ratio (X-axis) vs market value of firm and debt ratio (X-axis) vs WACC.

e. What can you comment from the two graphs?

** Please show all work**

Answer #1

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