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).