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Estimate of the new levered value of the firm

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1. (Ignore financial distress for this question)

Ocasa 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)?

Reference no: EM132602101

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