Capital structure practice(1)

# The risk free rate is 4 and the market risk premium

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The risk free rate is 4% and the market risk premium is 5%. You company faces a marginal tax rate of 30%. Exhibit 1 Exhibit 2 Rating Default Spread If EBIT Cov> EBIT Cov ≤ to Rating is AAA 30 8.50 100000 AAA AA 50 6.5 8.5 AA A+ 63 5.5 6.5 A+ A 71 4.5 5.5 A A- 84 3 4.5 A- BBB 117 2.5 3 BBB BB+ 190 2.25 2.5 BB+ BB 265 2 2.25 BB B+ 330 1.75 2 B+ B 395 1.5 1.75 B B- 720 1.25 1.5 B- CCC 1375 0.8 1.25 CCC CC 1600 0.65 0.8 CC C 1800 0.2 0.65 C D 2000 -100000 0.2 D Default spread in basis points (100 basis points = 1%)

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a) If you increase your debt ratio to 30%, what will be the EBIT coverage ratio, 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.) b) What will be the EBIT coverage ratio, credit rating, and interest rate if the debt ratio is 40%?
c) What is the unlevered beta of your common stock? d) What will be the levered betas at the debt ratio of 20%, 30%, and 40%? Calculate the corresponding cost of equity using CAPM. e) Calculate the WACC under the three debt ratios? Which debt ratio will you choose to maximize firm value?
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