EIEIO Agriculture Inc. is a sole proprietorship company that is located in New Bedford Nova Scotia that is owned by your best friend and they have come to you for advice – don’t disappoint them. Your friend is the only owner. The company is currently an un-levered firm. A company in this type of industry has a beta of 1.428571429 and you observe that government t-bills are selling to yield 3% and the market portfolio has an expected return of 10%. Your friend expects that they will be able to earn the required rate of return forever on an expected before tax earnings of $800,000 per year. Note: all final rates carry 6 decimal places.
Assuming that the tax rate is 40 percent and now, there is a cost for the risk of default. As the firm issues more and more debt in its capital structure, the risk for the shareholders and the debtholders will increase. This will have an impact on the value of the firm and the price the new shares will sell for when the shares are issued. (6 marks)
Calculate the required rate of return for the un-levered firm. Show all of your work.
Calculate the market value of the un-levered firm using proposition I. Show all of your work.
Calculate the WACC for an un-levered firm using proposition II. Show all of your work.