Question

* NCI, an unlevered
firm, has expected earnings before interest and taxes of $2 million
per year. NCI's tax rate is 40%, and the market value is V=E=$12
million. The stock has a beta of 1.00, and the risk free rate is
9%. [Assume that market risk premium is 6%. Management
is considering the use of debt; debt would be issued and used to
buy back stock, and the size of the firm would remain constant. The
default free interest rate on debt is 12%. Since interest expense
is tax deductible, the value of the firm would tend to 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, approximately, that the present value of
any bankruptcy cost is $8 million and the probability of bankruptcy
will increase with leverage according to the following
schedule:*

*Value of
debt
Probability of failure*

*$
2,500,000
0.00%*

*$
5,000,000
8.00%*

*$
7,500,000
20.5%*

*$
8,000,000
30.0%*

*$
9,000,000
45.0%*

*$10,000,000
52.5%*

*$12,500,000
70.0%*

*a. What is the cost of equity and
WACC at this time?*

*b. What is the optimal capital
structure when bankruptcy costs are considered?*

*c. What will the value of the firm be at this optimal
capital structure*

Answer #1

A) Given:

EBIT | $2million |

Tax Rate | 40% |

Market Value | $12 million |

Beta | 1 |

Risk Free rate | 9% |

Market Risk premium | 6% |

Default free interest in debt(Kd) | 12% |

Interest expense is tax deductable

Cost of Equity(Ke) = Risk Free Rate+ Beta*(Market Risk Premium)

9%+1*6%

15%.

**WACC Formula** = (E/V * Ke) + (D/V) * Kd
* (1 – Tax rate)

- E = Market Value of Equity.($12 million)
- V = Total market value of equity & debt.($20 million)
- Ke = Cost of Equity.(15%)
- D = Market Value of Debt.($8 million)
- Kd = Cost of Debt.(12%)
- Tax Rate = Corporate Tax Rate.(40%)

WACC = (12000000/20000000)*.15+ (8000000/20000000)*.12*(1-.4)

=11.88%

The Cost of Equity is 15% and the WACC is 11.88% at this time.

An unlevered firm has a cost of capital of 16% and earnings
before interest and taxes of $225,000. A levered firm with the same
operations and assets has both a book value and a face value of
debt of $850,000 with an 8% annual coupon. Assume no taxes, no
bankruptcy. What is the value of equity for the levered firm?
Select one:
A. 624,250
B. 556,250
C. 850,000
D. 556,250

Jemisen's firm has expected earnings before interest and taxes
of $1,400. Its unlevered cost of capital is 13 percent and its tax
rate is 34 percent. The firm has debt with both a book and a face
value of $1,800. This debt has a 7 percent coupon and pays interest
annually. What is the firm's weighted average cost of capital?
A) 12.03 percent
B) 12.88 percent
C) 12.50 percent
D) 11.97 percent
E) 12.20 percent

Hanover Industries has expected earnings before interest and
taxes of $630,300, an unlevered cost of equity of 14.7 percent, and
a combined tax rate of 23 percent. The company also has 11,000
senior bonds outstanding that carry a coupon rate of 7 percent. The
debt is selling at par value. What is the value of this company?
What is the target capital structure of the firm if the levered
cost of equity is 17.25? Assume MM with taxes holds.

Hanover Industries has expected earnings before interest and
taxes of $630,300, an unlevered cost of equity of 14.7 percent, and
a combined tax rate of 23 percent. The company also has
11,000senior bonds outstanding that carry a coupon rate of 7
percent. The debt is selling at par value. What is the value of
this company? What is the target capital structure of the firm if
the levered cost of equity is 17.25? Assume MM with taxes
holds.

5. Hanover Industries has expected earnings before interest and
taxes of $630,300, an unlevered cost of equity of 14.7 percent, and
a combined tax rate of 23 percent. The company also has 11,000
senior bonds outstanding that carry a coupon rate of 7 percent. The
debt is selling at par value. What is the value of this company?
What is the target capital structure of the firm if the levered
cost of equity is 17.25? Assume MM with taxes holds.

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million in earnings before interest and taxes (EBIT) each year. The
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million in debt with a pre-tax cost of 7% to its capital structure
and using the proceeds to reduce equity by a like amount as to keep
total invested capital unchanged. The firm pays a tax rate of
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Assuming that the company's EBIT stream...

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and a tax rate of 33 percent. The company also has $2,900 of debt
that carries an 8 percent coupon. The debt is selling at par value.
What is the value of this firm?

An unlevered company with a cost of equity of 11% generates $5
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decides to alter its capital structure to include debt by adding $5
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Assuming that the company's EBIT stream...

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Net income is expected to stay constant forever. The firm pays out
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Using the CAPM, the firm estimates that its cost of equity is
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The firm is considering issuing bonds worth...

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