Gamma Medical Company is currently an un-levered firm with a beta of 1.3925. Government of Canada T-bills are yielding 3% and the market risk premium is 8%. You expect the company will be able to earn the required rate of return forever on an expected before tax earnings of $800,000 per year.
Assuming that the tax rate is 40% and now, there is a cost for the risk of default. Use the following table to answer these questions:
Value of Debt RD Beta
EBIT 800,000 0 5.0% 1.3925
Tax Rate 40% 250,000 5.5% 1.483015
T-bill Rate 3.0% 500,000 6% 1.542274
TSX 11.0% 750,000 6.5% 1.607016
1,000,000 7.0% 1.678038
1,250,000 9.0% 1.756303
1,500,000 11.0% 1.842075
1,750,000 13.0% 1.939488
2,000,000 15.0% 2.047619
a) Calculate the required rate of return for the un-levered firm.
b) Calculate the market value of the un-levered firm using proposition I.
c) Calculate the WACC for an un-levered firm using proposition II. No calculation required
d) Using the information from the table, calculate the value of the firm (proposition I), cost of equity, and the WACC (proposition II) of the firm if the firm issues $500,000 of debt.
e) Using the information from the table, if the firm issues $2,000,000 in debt, what would you expect to happen to the total value of the firm, cost of equity and the WACC? Briefly explain. No calculations required.