Problem:
The CEO of a company is worried about his company's level of debt financing. The company uses short-term debt to finance its temporary working capital needs, but it does not use any permanent (long-term) debt. Other companies in the same industry average about 30% debt, while the CEO wonders why they use so much more debt and how it affects stock prices. To gain some insights into the matter, he poses the following questions to you, his recently hired assistant:
Assume that firms U and L are in the same risk class, and that both have EBIT = $500,000. Firm U uses no debt financing and its cost of equity is Rsu = 14%. Firm L has $1 million of debt outstanding at a cost of Rd = 8%. There are no taxes. Assume that the MM assumptions hold, and then: (2 QUESTIONS)
1) Graph (a) the relationships between capital costs and leverage as measured by D/V, and (b) the relationship between value and D.
2) Using the data given in part b, but now assuming that Firms L and U are both subject to a 40% corporate tax rate, repeat the analysis called for in b-(1) and b-(2) under the MM with-tax model.