The disadvantage is that using debt introduces financial risk into the firm because there are required periodic cash payments (interest and principal). The effective annual interest rate for each loan proposal can be calculated as: Bank A: Bank B:
Ron Muller 2007-08 4 Bank C: Bank D: You should choose Bank B since the effective annual interest rate on that loan is the lowest, at 6.25%.
Ron Muller 2007-08 5 Question 2 (June 2006)18 marks DEF Corp. is currently an all-equity firm. It needs to raise $2.5 million in additional funds. After raising the funds, it expects earnings before interest and taxes (EBIT) to be $600,000. The firm’s unlevered cost of equity, kU, is 12%, and its before-tax cost of debt, kB, is 8%. Required: a. If there are no corporate taxes, in a perfect Modigliani and Miller (M&M) world, what is the value of DEF if it issues common shares to raise the needed funds? Alternatively, what is the firm’s new cost of equity and the value of the firm if it issues debt to raise the needed funds? What is its opportunity cost of capital? What is the fundamental determinant of the value of the firm in the M&M no-tax case? b. Now assume that the corporate tax rate is 35%. i) What is the all-equity value of DEF? ii) What is DEF’s value if $2.5 million in debt is issued? What is the new kE? What is the new opportunity cost of capital? iii) Assume the debt is now $4 million. What is DEF’s value? What is the new kE? What is the new opportunity cost of capital? c. Based on your answers to parts a) and b), what role do debt financing and corporate tax play in a firm’s capital structure decision? What other factors does a firm need to consider?
Ron Muller 2007-08 6 Solution to Question 2 a. In a no-tax M&M perfect world, after raising the fund by issuing common shares, The current common equity is $5,000,000 – $2,500,000 = $2,500,000. If $2.5 million is to be raised by issuing debt, b. In an M&M world with corporate tax:
Ron Muller 2007-08 8
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