Response to the following problem:
International Associates (IA) is just about to commence operations as an international trading company. The firm will have book assets of $10 million, and it expects to earn a 16 percent return on these assets before taxes. However, because of certain tax arrangements with foreign governments, IA will not pay any taxes; that is, its tax rate will be zero. Management is trying to decide how to raise the required $10 million. It is known that the capitalization rate for an all-equity firm in this business is 11 percent; that is, rU 11%. Further, IA can borrow at a rate rd 6%. Assume that the MM assumptions apply.
a. According to MM, what will be the value of IA if it uses no debt? If it uses $6 million of 6 percent debt?
b. What are the values of the WACC and rs at debt levels of D = $0, D = $6 million, and D $10 million? What effect does leverage have on firm value? Why?
c. Assume the initial facts of the problem (rd = 6%, EBIT = $1.6 million, rsU = 11%), but now assume that a 40 percent federal-plus-state corporate tax rate exists. Find the new market values for IA with zero debt and with $6 million of debt, using the MM formulas.
d. What are the values of the WACC and rs at debt levels of D = $0, D $6 million, and D = $10 million, assuming a 40 percent corporate tax rate? Plot the relationships between the value of the firm and the debt ratio, and between capital costs and the debt ratio.
e. What is the maximum dollar amount of debt financing that can be used? What is the value of the firm at this debt level? What is the cost of this debt?
f. How would each of the following factors tend to change the values you plotted in your graph?
(1) The interest rate on debt increases as the debt ratio rises.
(2) At higher levels of debt, the probability of financial distress rises.