Question

Problem #2

Westbrook Water Co. is an all equity company with EBIT of $2,000,000 per year which will continue forever as the company pays out all earnings in the form of dividends (i.e. no growth).

You must determine the optimal capital structure for this company. You have been provided with the following additional information: T-bills are currently yielding 1.5%; the expected return on the market is 8.5%; the company’s tax rate is 40%; and costs of financial distress apply. Assume the market value of debt is equal to its book value.

Value of Debt	Cost of Debt (Rd)	Beta	PV of Financial Distress Costs
$0	-	1.25	-
$2,500,000	4%	1.45	?
$4,000,000	5%	?	$740,000

a)                  What is the value and WACC of this all-equity firm?

b)                  What would be the value of the company if it issues $2.5 million in debt?

c)                  What would the PV of financial distress costs be if the firm issues $2.5million in debt?

d)                  What would be the value of the company if it issues $4 million in debt?

e)                  What would be the company’s Beta if it issues $4 million in debt?

f)                   What is the optimal capital structure: 0, $2,500,000, or $4,000,000?

Answer 1

since multiple subparts posted i will solve a to d
a)usinf capm model we can find cost of equity
risk free+(beta*(market return-risk free))
=1.5%+(1.25*(8.5%-1.5%))
=10.25%
Value of firm= EBIT*(1-tax)/cost of equity
=2000000*(1-40%)/10.25%
=11707317.07
b)Value of company:
Here we need to find WACC
=(cost of debt*wt of debt)+(cost of equity*wt of equity)
wt of debt=2500000/4000000=62.50%
Wt of equity=1-62.5%=37.50%
After tax cost of debt=4%*(1-40%)=2.4%
Cost of equity=1.5%+(1.45*(8.5%-1.5%))=11.65%
WACC=(62.5%*2.4%)+(37.5%*11.65%)=5.87%
value of company=(2000000-(2500000*4%))*(1-40%)/5.87%
=19420783.65
c)