A firm would have to invest $1 million to earn a net return of $500 million next year. The firm estimates its debt cost of capital to be E(r˜Debt) = 5% + 10% . w2 Debt. (This may be the case for different reasons covered in the next chapter.) The firm is in the 25% marginal tax bracket.
(a) If the firm is fully equity-financed, what is its value?
(b) Using APV, if the firm is financed with equal amounts of debt and equity today, what is its value?
(c) Using WACC, if the firm is financed with equal amounts of debt and equity today, what is its value?
(d) Does this firm have an optimal capital structure? If so, what is its APV and WACC?