Reference no: EM132211675

Problem 1 - "UB is examining its capital structure with the intent of arriving at an optimal debt ratio. It currently has no debt and has a beta of 1.5. The riskless interest rate is 9%. Your research indicates that the debt rating will be as follows at different debt levels:"

D/(D + E) (%)	Rating	Interest Rate (%)
0	AAA	10
10	AA	10.5
20	A	11
30	BBB	12
40	BB	13
50	B	14
60	CCC	16
70	CC	18
80	C	20
90	D	25

The firm currently has 1 million shares outstanding at $20 per share (tax rate = 40%).

a) What is the firm optimal debt ratio?

b) Assuming that the firm restructures by repurchasing stock debt, what will the value of the stock be after the restructuring? (with 5% growth in perpetuity)

Problem 2 - Terck, a leading pharmaceutical company, currently has a balance sheet that is as follows:

Liability		Assets
Long-term bonds	$1,000	Fixed assets	$1,700
Equity	$1,000	Current assets	$300
Total	$1,000	Total	$1,000

The firm's income statement looks as follows:

Revenues	$1,000
Cost of goods sold (COGS)	$400
Depreciation	$100
EBIT	$500
Long-term interest expense	$100
EBT	$400
Taxes	$200
Net income	$200

The firm's bond are all 20 years bond with a coupon rate of 10% that are selling at 90% of face value (the yield to maturity on these bonds is 11%).

The stocks are selling at a P/E ratio of 9 and have a beta of 1.25. The risk-free rate is 6%.

a) What is the firm current cost of equity?

b) What is the firm's current after-tax cost of debt?

c) What is the firm's current weighted average cost of capital?

Assume that management of Terck, which is very conservative, is considering doing an equity-for-debt swap (i.e. issuing $200 more of equity to retire $200 of debt). This action is expected to lower the firm's interest rate by 1%.

d) What is the firm's new cost of equity?

e) What is the new WACC?

f) What will the value of the firm be after the swap? (zero growth rate).