Capital structure practice solution(1)

# Hint compute the ebit coverage ratio using the

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Credit rating, and interest rate? (Hint: Compute the EBIT coverage ratio using the current interest rate. Based on this ratio, find the corresponding credit rating and new interest rate. Then compute the EBIT coverage ratio again with the new interest rate. Repeat this procedure until the EBIT coverage ratio, credit rating, and interest rate are lined up in the same row.) (5 points) The size (total value) of the firm is \$200m debt + \$800m equity = \$1b. The size will remain unchanged. @ 30% debt, assuming current interest, interest expense is \$300m * 4.3% = \$12.9m EBIT coverage = \$80m/\$12.9m = 6.2, which corresponds to A+ rating @ A+ rating, the interest increases to 4.63% (Rf + default spread of A+ rating) Interest expense is \$300m * 4.63% = \$13.89m EBIT coverage = \$80m/\$13.89m = 5.76, which still corresponds to A+ rating. Therefore, at 30% debt ratio, you will have EBIT coverage ratio of 5.76, credit rating of A+, and interest rate of 4.63%. b) What will be the EBIT coverage ratio, credit rating, and interest rate if the debt ratio is 40%? (5 points) @ 40% debt, assuming current interest, interest expense is \$400m * 4.3% = \$17.2m EBIT coverage = \$80m/\$17.2m = 4.65, which corresponds to A rating @ A rating, the interest increases to 4.71% (Rf + default spread of A rating) Interest expense is \$400m * 4.71% = \$18.84m EBIT coverage = \$80m/\$18.84m = 4.246, which corresponds to A- rating. @ A- rating, the interest increases to 4.84% (Rf + default spread of A- rating) Interest expense is \$400m * 4.84% = \$19.36m EBIT coverage = \$80m/\$19.36m = 4.132, which still corresponds to A- rating. Therefore, at 40% debt ratio, you will have EBIT coverage ratio of 4.132, credit rating of A-, and interest rate of 4.84%.

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c) What is the unlevered beta of your common stock? (5 points) The stock beta of 1.5 is the levered beta at the D/E ratio of 0.25 (\$200m/
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• Spring '09
• SA'EED
• Debt, Weighted average cost of capital, Credit rating, EBIT coverage ratio

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