As a firm takes on more debt, its probability of bankruptcy faces a other factor
ID: 2792049 • Letter: A
Question
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. Green Goose Automation Company 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 1.15, and its cost of equity is 13.78%. Because the fimm has no debt in its capital structure, its weighted average cost of capital (WACC) also equals 13.78%. The risk-free rate of interest (r r) is 4%, and the market risk premium (RP) is 8.5%, Green Goose's marginal tax rate is 40%. Green Goose 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 Bond Cost of Debt Levered Cost of D/A E/A Ratio Ratio D/E Ratio Rating 0.0 1.0 0.2 0.8 0.25 A 7.2% 15.22% 13.04% 0.4 0.6 Beta (b) Equity (r) WACC 13.78% (ra) 0.00 1.15 13.78% 7% 1.61 17.69% [ 0.67 7.796 0.6 0.4 1.50 BB 8.9% 2.19 12.25% 0.8 0.2 c 11.9% 3.91 37.24%Explanation / Answer
As a firm takes on more debt the probability of bankruptcy increases. Other factors held constant, a firm whose earnings are relatively volatile faces a higher chance of bankruptcy.Therefore when other factors are held constant, a firm whose earnings are relatively volatile should use less debt than a more stable firm. When bankruptcy costs become more important, they outweigh the tax benefits of debt
WACC=D/A*before tax cost of debt*(1-tax rate)+E/A*cost of equity
D/E=(D/A)/(E/A)
Cost of equity=risk free+beta*market risk premium
Hence,
D/A=0.2: cost of equity=15.22%
Hence,levered beta=(15.22%-4%)/8.5%=1.32
D/A=0.4: WACC=0.4*7.7%*(1-40%)+0.6*17.69%=12.462%
D/A=0.6: Cost of equity=4%+2.19*8.5%=22.615%
D/A=0.8: D/E=0.8/0.2=4
WACC=0.8*11.9%*(1-40%)+0.2*37.24%=13.16%
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