4. Firm XYZ currently has a capital structure of 30% debt and 70% equity. The co

Question

4. Firm XYZ currently has a capital structure of 30% debt and 70% equity. The cost of debt is currently 6% and the cost of equity is 12%. The value of debt is $300 million and the value of equity is $700 million. Let the tax rate equal 34%. An investment banker tells the CFO of the company that if the firm increases its leverage ratio, the cost of debt will increase according to the following schedule:

Cost of Debt

Assume that the cash flow of the firm may be represented as a perpetuity. Determine the WACC for each debt level. Determine the value of the firm for each firm level.

Cost of Debt

Explanation / Answer

Percentage Debt Percentage equity Cost of Debt 30% 70% 6% 40% 60% 7% 50% 50% 8% Cost of Debt Cost of Debt after tax Cost of Debt after tax 6% 6%*(1-.34) 3.96% 7% 7%*(1-.34) 4.62% 8% 8%((1-.34 5.28% WACC WACC EBIT Value of firm 3.96%*.3+12%*.7 9.59% 145.27           1,515.12 4.62%*.4+12%*.6 9.05% 145.27           1,605.55 3.96%*.5+12%*.5 7.98% 145.27           1,820.43 PAT =700*12% 84 EBT=PAT/(1-.34)                                127.27 Add: Cost of Debt 300*6%                                   18.00 EBIT                                145.27

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