Question

Problem 1

Gamma Medical Company is currently an un-levered firm with a beta of 1.3925. Government of Canada T-bills are yielding 3% and the market risk premium is 8%. You expect the company will be able to earn the required rate of return forever on an expected before tax earnings of $800,000 per year.

1.      Assume that the tax rate is 40% and there is no cost for the risk of default.

a)        Calculate the required rate of return for the un-levered firm.

b)        Calculate the market value of the firm using proposition I.

c)         Calculate the WACC for the firm using proposition II. No calculation required. (1 mark)

d)        The current market interest rate for any debt issued by the company is 5%. If the firm issues $750,000 in debt, calculate the total value of the firm, cost of equity, and the WACC

e)        The current market interest rate for any debt issued by the company is 5%. If the firm issues $2,000,000 in debt, what would you expect to happen to the total value of the firm, cost of equity and the WACC? Briefly explain. No calculations required.

2.      Assuming that the tax rate is 40% and now, there is a cost for the risk of default. Use the following table to answer these questions:

		Value of
		Debt	RD	Beta
EBIT	800,000	0	5.0%	1.3925
Tax Rate	40%	250,000	5.5%	1.483015
T-bill Rate	3.0%	500,000	6%	1.542274
TSX	11.0%	750,000	6.5%	1.607016
		1,000,000	7.0%	1.678038
		1,250,000	9.0%	1.756303
		1,500,000	11.0%	1.842075
		1,750,000	13.0%	1.939488
		2,000,000	15.0%	2.047619

a)             Calculate the required rate of return for the un-levered firm.

b)             Calculate the market value of the un-levered firm using proposition I.

c)             Calculate the WACC for an un-levered firm using proposition II. No calculation required (1 mark)

2

d)             Using the information from the table, calculate the value of the firm (proposition I), cost of equity, and the WACC (proposition II) of the firm if the firm issues $500,000 of debt. (6 marks)

e)             Using the information from the table, if the firm issues $2,000,000 in debt, what would you expect to happen to the total value of the firm, cost of equity and the WACC? Briefly explain. No calculations required.

Answer 1