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You have the following information for Alpha plc:
Equity: 500,000 shares. The company just paid a dividend of £2 and the dividends are expected to grow by 3% per year indefinitely. The current share price is £20. The return of Alpha's equity has a standard deviation of 24% per annum and a correlation with the market of 0.9.
Debt: 10,000 bonds outstanding, with 20 years to maturity, a coupon rate of 7% and a face value of £1,000. The price of the bonds is £901.036 and they pay coupons semiannually.
The market risk premium is 6% and the standard deviation of the returns of the market is 15%. Treasury bills are yielding 4% and the corporate tax rate is 20%.
Now assume that you are financial manager of Alpha plc, and you have been asked by one of your large shareholders the following questions, "If debt can reduce the weighted average cost of capital, why does it then increase the risk of a company? Is it possible for financial manager to diversify bankruptcy risk away like other risks?" What are your answers to these questions? Explain.
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