1. Bourbon Street, Inc. has debt of $3,000 (face and market value). This debt has a coupon rate of 7% and pays interest annually. The expected annual earnings before interest and taxes is $1,200, the tax rate is 34%, and the unlevered cost of capital is 12%. What is the firm's cost of equity?
2. (Ignore financial distress for this question) Pisa Corporation is currently an all-equity firm that has 80,000 shares of stock outstanding with a market price of $42 a share. The current cost of equity is 12% and the tax rate is 34%. Pisa's management is considering adding $1 million of debt with a coupon rate of 8% to the capital structure and using the money to repurchase stock. The debt will be sold at par.
a. What is your estimate of the new levered value of the firm?
b. Now increase the debt used to repurchase stock to $3 million. What is the value of the levered firm now? Why does the value of the firm change, if at all, from your answer to part (a)?
c. Compare your answers in parts (a) and (b). What does this say about the optimal capital structure for a firm in a world of taxes (but no financial distress)?
3. A firm has zero debt in its capital structure. Its overall cost of capital is currently 9%. The firm is considering a new capital structure with 40% debt. The interest rate of the debt would be 4% no matter what amount of debt is taken on.
a. Assuming that the corporate tax rate is 34%, what would be the firm's cost of equity and WACC with the new capital structure?
b. Now increase the new capital structure to a D/E ratio of 2.333333. What would the cost of equity be now? What about the WACC?
c. Why does the cost of equity and the WACC change, if at all, from part (a) to part (b)?
4. Is there an easily identifiable debt-equity ratio that will maximize the value of a firm in a world with taxes and financial distress? Why or why not?