Question: Intel has earnings before interest and taxes of $ 3.4 billion, and faces a marginal tax rate of 36.50%. It currently has $ 1.5 billion in debt outstanding, and a market value of equity of $ 51 billion. The beta for the stock is 1.35, and the pre-tax cost of debt is 6.80%. The treasury bond rate is 6%. Assume that the firm is considering a massive increase in leverage to a 70% debt ratio, at which level the bond rating will be C (with a pre-tax interest rate of 16%).
a. Estimate the current cost of capital.
b. Assuming that all debt gets refinanced at the new market interest rate, what would your interest expenses be at 70% debt? Would you be able to get the entire tax benefit? Why or why not?
c. Estimate the beta of the stock at 70% debt, using the conventional levered beta calculation. Reestimate the beta, on the assumption that C rated debt has a beta of 0.60. Which one would you use in your cost of capital calculation?
d. Estimate the cost of capital at 70% debt.
e. What will happen to firm value if Intel moves to a 70% debt ratio?
f. What general lessons on capital structure would you draw for other growth firms?