An unlevered firm, Marshall Inc., has a constant EBIT of $1,500,000 per year in perpetuity. It is considering the use of some debt financing to repurchase shares. Based on the PV of bankruptcy costs of $2,500,000, the following schedule has been developed:
Value of Debt Probability of financial distress
$200,000 0.00%
600,000 1.00%
1,000,000 2.00%
2,000,000 7.00%
3,000,000 15.00%
4,000,000 40.00%
5,000,000 65.00%
The current cost of equity is 18%, and the tax rate is 40%. Assume that the company can borrow at a cost of 10%.
a) What is Marshallâs market value and the WACC before any debt is taken on?
b) In M&Mâs case (world) II, what is Marshallâs optimal level of debt?
c) What is the optimal capital structure when financial distress costs are included?
d) Compute the WACC at the optimal capital structure determined in part (c).
An unlevered firm, Marshall Inc., has a constant EBIT of $1,500,000 per year in perpetuity. It is considering the use of some debt financing to repurchase shares. Based on the PV of bankruptcy costs of $2,500,000, the following schedule has been developed:
Value of Debt Probability of financial distress
$200,000 0.00%
600,000 1.00%
1,000,000 2.00%
2,000,000 7.00%
3,000,000 15.00%
4,000,000 40.00%
5,000,000 65.00%
The current cost of equity is 18%, and the tax rate is 40%. Assume that the company can borrow at a cost of 10%.
a) What is Marshallâs market value and the WACC before any debt is taken on?
b) In M&Mâs case (world) II, what is Marshallâs optimal level of debt?
c) What is the optimal capital structure when financial distress costs are included?
d) Compute the WACC at the optimal capital structure determined in part (c).
Related questions
GOAL is trying to determine its optimal capital structure. The Companyâs capital structure consists of debt and common stock. In order to estimate the cost of debt, the company has produced the following table:
| D/V | Rating | Cost of Debt |
| 0.1 | AA | 7.00% |
| 0.2 | A | 7.2 |
| 0.3 | A | 8 |
| 0.4 | BB | 8.8 |
| 0.5 | B | 9.6 |
The companyâs tax rate is 40 percent. The company uses the CAPM model to estimate its cost of equity. The risk-free rate is estimated to be 5 percent and the equity market risk premium is 6 percent. Companyâs estimate of its asset beta is 1.05
Companyâs operating profit (EBIT) is expected to be $2,000,000 in the foreseeable future. Assume no net investment in fixed assets (only depreciated assets are replenished) and working capital. ABC currently has 1,000,000 outstanding shares.
1) Assume that company is planning to recapitalize to reach an optimal capital structure. Assuming that company will use the new debt to repurchase its shares, for each D/V level determine
a) Market Value of Firm
b) Cost of equity
c) Share Price after the recapitalization announcement
d) Number of shares outstanding following the stock repurchase
e) Market Value of Equity
f) WACC and Optimal Capital Structure
g) At what level of debt, companyâs WACC is minimized? Explain.
2) Reflect on what you have learned about firmâs choice of capital structure in the light of the question above. What other considerations are given in determining capital structure in practice that is not captured in the context of the current question?
ABC is trying to determine its optimal capital structure. The Companyâs capital structure consists of debt and common stock. In order to estimate the cost of debt, the company has produced the following table:
| D/V | Rating | Cost of Debt |
| 0.1 | AA | 7.00% |
| 0.2 | A | 7.2 |
| 0.3 | A | 8 |
| 0.4 | BB | 8.8 |
| 0.5 | B | 9.6 |
The companyâs tax rate is 40 percent. The company uses the CAPM model to estimate its cost of equity. The risk-free rate is estimated to be 5 percent and the equity market risk premium is 6 percent. Companyâs estimate of its asset beta is 1.05
Companyâs operating profit (EBIT) is expected to be $2,000,000 in the foreseeable future. Assume no net investment in fixed assets (only depreciated assets are replenished) and working capital. ABC currently has 1,000,000 outstanding shares.
1) On the basis of this information, what are the unlevered companyâs market value and its share price?
2) Assume that company is planning to recapitalize to reach an optimal capital structure. Assuming that company will use the new debt to repurchase its shares, for each D/V level determine
a) Market Value of Firm
b) Cost of equity
c) Share Price after the recapitalization announcement
d) Number of shares outstanding following the stock repurchase
e) Market Value of Equity
f) WACC and Optimal Capital Structure
g) At what level of debt, companyâs WACC is minimized? Explain.
3) Reflect on what you have learned about firmâs choice of capital structure in the light of the question above. What other considerations are given in determining capital structure in practice that is not captured in the context of the current question?
