A firm has perpetual constant FCFs, 10 million shares outstanding trading at $50 per share, and debt of $200 million. The current equity beta is 1.5, risk free rate is 8%, MRP is 5.5%, cost of debt is 11%, and tax rate is 46%. It is considering adding $100 million of debt, which would push its cost of debt to 12.5%.
a) Would you recommend this change?
b) If the debt actually increases (keeping operating cash flows unchanged), what would be the change in firm value? Assuming that all of this change flows into equity value, what would be the change in price per share?
c) Assume that the firm has a project that requires $100 initial investment (funded via an increase in debt, as above), that will create incremental before-tax cash flows of $20 million per year (same risk as existing projects), forever. Should the firm undertake it? What if the cash flows from the project are risk free?