T-bills are currently yielding 1.5%; the expected return on the market is 8.5%; the company’s tax rate is 40%; and costs of financial distress apply. Assume the market value of debt is equal to its book value.
Value of Debt Cost of Debt (Rd) Beta PV of Financial Distress Costs
$0 - 1.25 -
$2,500,000 4% 1.45 ?
$4,000,000 5% ? $740,000
a) What is the value and WACC of this all-equity firm?
b) What would be the value of the company if it issues $2.5 million in debt?
c) What would the PV of financial distress costs be if the firm issues $2.5million in debt?
d) What would be the value of the company if it issues $4 million in debt?
e) What would be the company’s Beta if it issues $4 million in debt?
f) What is the optimal capital structure: 0, $2,500,000, or $4,000,000?