Here is Establishment Industries's market-value balance sheet (figures in millions):
NET WORKING CAPITAL 550 DEBT 800
LONG TERM ASSETS 2150 EQUITY 1900
VALUE OF THE FIRM 2700 2700
The debt is yielding 7 percent, and the cost of equity is 14 percent. The tax rate is 35 percent. Investors expect this level of debt to be permanent.
a.What is Establishment's WACC?
b.Write out a market-value balance sheet assuming Establishment has no debt.
Costs of Financial Distress. For which of the following firms would you expect the costs of financial distress to be highest? Explain briefly.
c. A computer software company that depends on skilled programmers to produce new products.
d. A shipping company that operates a fleet of modern oil tankers.
Trade-Off Theory. Smoke and Mirrors currently has EBIT of $25,000 and is all-equity-financed. EBIT is expected to stay at this level indefinitely. The firm pays corporate taxes equal to 35 percent of taxable income. The discount rate for the firm's projects is 10 percent.
e. What is the market value of the firm?
f.Now assume the firm issues $50,000 of debt paying interest of 6 percent per year, using the proceeds to retire equity. The debt is expected to be permanent. What will happen to the total value of the firm (debt plus equity)?
g. Recompute your answer to (b) under the following assumptions: The debt issue raises the probability of bankruptcy. The firm has a 30 percent chance of going bankrupt after 3 years. If it does go bankrupt, it will incur bankruptcy costs of $200,000. The discount rate is 10 percent. Should the firm issue the debt?
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