Reference no: EM132597008

The following data reflect the current financial condition of the Levine Corporation:

Value of debt (book =market)               1,000,000

Market value of equity                         5,257,143

Sales, last 12 months                        12,000,000

Variable operating costs (50% of sales) 6,000,000

Fixed operating costs                         5,000,000

Tax rate, T (federal-plus-state)              40%

• At the current level of debt, the cost of debt, kd, is 8% and the cost of equity, ks, is 10.5%. Management questions whether or not the capital structure is optimal, so the financial vice-president has been asked to consider the possibility of issuing $1 million of additional debt and using the proceeds to repurchase stock. It is estimated that if the leverage were increased by raising the level of debt to $2 million, the interest rate on new debt would rise to 9% and ks, would rise to 11.5%. The old 8% debt is senior to the new debt, and it would remain outstanding, continue to yield 8%, and have a market value of $1 million. The firm is a zero-growth firm, with all of its earnings paid out as dividend.

Required Questions:

Question 1. Should the firm increase its debt to $2 million?

Question 2. If the firm decided to increase its level of debt to $3 million, its cost of the additional $2 million of debt would be 12% and Ks, would rise to 15%. The original 8% of debt would again remain outstanding, and its market value would remain $1 million. What level of debt should the firm choose: $1 million, $2 million, or $3 million?

Question 3. What would happen to the value of the old bonds if the firm uses more leverage and the old bonds are not senior to the new bonds?