7. Capital structure theory Aa Aa As a firm takes on more debt, its probability

Question

7. Capital structure theory Aa Aa As a firm takes on more debt, its probability of bankruptcy faces a Other factors held constant, a firm whose earnings are relatively volatile chance of bankruptcy. Therefore, when other factors are held constant, a firm whose earnings are relatively volatile should use debt than a more stable firm. When bankruptcy costs become more important, they the tax benefits of debt. General Forge and Foundry Corporation currently has no debt in its capital structure, but it is considering using some debt and reducing its outstanding equity. The firm's unlevered beta is 1.05, and its cost of equity is 11.90%. Because the firm has no debt in its capital structure, its weighted average cost of capital (WACC) also equals 11.90%. The risk-free rate of interest (TRF) is 3.5%, and the market risk premium (RP) is 8% General Forge's marginal tax rate is 30% General Forge is examining how different levels of debt will affect its costs of debt and equity, as well as its WACC. The firm has collected the financial information that follows to analyze its weighted average cost of capital (WACC). Complete the following table Before-Tax Cost of Debt (rd) Levered Beta (b) 1.05 Bond Cost of Equity (rs) 11.90% 13.34% 15.82% D/A E/A Ratio Ratio D/E Ratio Rating WACC 11.90% 11.85% 0.0 0.2 0.4 0.6 0.8 0.00 0.25 0.67 1.50 0.8 8.4% 1.54 2.15 3.99 0.6 8.9% 12.94% 0.2 14.3% 35.42%

Explanation / Answer

As a firm takes on more debt, its probability of bankruptcy increases , other factors held constant , a firm whose earnings are relatively volatile faces a greater chance of bankruptcy.Therefore, when other factors are held constant , a frim whose earnings are realtively volatile should use less debt than a more stable firm.When bankruptcy costs become more important , they reduce the tax benefit of debt.

0.8 / 0.2

= 4

Note:- Bond A:-

Cost of equity = risk free rate + beta * market risk premium

13.34% = 3.5% + beta * 8%

  13.34%-3.5% = beta * 8%

beta = 0.0984 / 0.08

beta = 1.23

  Bond BBB :-

   WACC = Debt / total value * cost of debt (after tax) +  equity / total value * cost of equity

= 0.67 / 1.67 * [8.9% * (1-0.30)] + 1 / 1.67 * 15.82%

= 0.67 / 1.67 * 6.23% + 1 / 1.67 * 15.82%

= 2.50% + 9.47%

= 11.97%

Bond BB :-

Cost of equity = risk free rate + beta * market risk premium

= 3.5% + 2.15 * 8%

= 3.5% + 17.2%

= 20.7%

    Bond C :-

WACC = Debt / total value * cost of debt (after tax) +  equity / total value * cost of equity

= 4/ 5 * [14.3% * (1-0.30)] + 1 /5 * 35.42%

= 4/ 5 *10.01% + 7.084%

= 8.008% + 7.084%

=15.09%

D/A ratio E/A ratio D/E ratio Bond Rating Before-tax cost of debt Levered beta Cost of equity WACC 0.0 1.0 0.00 - - 1.05 11.90% 11.90% 0.2 0.8 0.25 A 8.4% 1.23 13.34% 11.85% 0.4 0.6 0.67 BBB 8.9% 1.54 15.82% 11.97% 0.6 0.4 1.50 BB 11.1% 2.15 20.7% 12.94% 0.8 0.2

0.8 / 0.2

= 4

C 14.3% 3.99% 35.42% 15.09%

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