Question: Baldor Electric, a company which gets 85% of its revenues from industrial electric motors, had 27.5 million shares at $ 25 per share, and $ 25 million in debt outstanding at the end of 1995. The firm has a beta of 0.70, had earnings before interest and taxes of $63.3 million and a book value of equity of $200 million. The following table summarizes the ratings and interest rates for Baldor Electric at different levels of debt.
The tax rate is 35%.
a. Estimate the cost of equity at each level of debt.
b. Estimate the return on equity at each level of debt.
c. Estimate the optimal debt ratio based upon the differential return.
d. Will the value of the firm be maximized at this level of debt. Why or why not?