Okg

15.00%

The tax rate is 35%.

a. Estimate the cost of equity at each level of debt.

b. Estimate the return on equity at each level of debt.

c. Estimate the optimal debt ratio based upon the differential return.

d. Will the value of the firm be maximized at this level of debt. Why or why not?

14. Pfizer, one of the largest pharmaceutical companies in the United States, is considering what its debt capacity is. In March 1995, Pfizer had an outstanding market value of equity of $ 24.27 billion, debt of $ 2.8 billion and a AAA rating. Its beta was 1.47, and it faced a marginal corporate tax rate of 40%. The treasury bond rate at the time of the analysis was 6.50%, and AAA bonds trade at a spread of 0.30% over the treasury rate.

a. Estimate the current cost of capital for Pfizer.

b. It is estimated that Pfizer will have a BBB rating if it moves to a 30% debt ratio, and that BBB bonds have a spread of 2% over the treasury rate. Estimate the cost of capital if Pfizer moves to its optimal.

c. Assuming a constant growth rate of 6% in the firm value, how much will firm value change if Pfizer moves its optimal? What will the effect be on the stock price?

d. Pfizer has considerable research and development expenses. Will this fact affect whether Pfizer takes on the additional debt?

15. Upjohn, another major pharmaceutical company, is also considering whether it should borrow more. It has $ 664 million in book value of debt outstanding, and 173 million shares outstanding at $ 30.75 per share. The company has a beta of 1.17, and faces a tax rate of 36%. The treasury bond rate is 6.50%.

a. If the interest expense on the debt is $ 55 million, the debt has an average maturity of 10 years, and the company is currently rated AA- (with a market interest rate of 7.50%), estimate the market value of the debt.

b. Estimate the current cost of capital.

c. It is estimated that if Upjohn moves to its optimal debt ratio, and no growth in firm value is assumed, the value per share will increase by $ 1.25. Estimate the cost of capital at the optimal debt ratio.

16. Nucor, an innovative steel company, has had a history of technical innovation and financial conservatism. In 1995, Nucor had only $ 210 million in debt outstanding (book as well as market value), and $ 4.2 billion in market value of equity (with a book value of $ 1.25 billion). In the same year, Nucor had earnings before interest and taxes of $ 372 million, and faced a corporate tax rate of 36%. The beta of the stock is 0.75, and the company is AAA rated (with a market interest rate of 6.80%).

a. Estimate the return differential between return on equity and cost of equity at the current level of debt.

b. Estimate the return differential at a debt ratio of 30%, assuming that the bond rating will drop to A-, leading to market interest rate of 8.00%.

17. Bethlehem Steel, one of the oldest and largest steel companies in the United States, is considering the question of whether it has any excess debt capacity. The firm has $ 527 million in market value of debt outstanding, and $ 1.76 billion in market value of equity. The firm has earnings before interest and taxes of $ 131 million, and faces a corporate tax rate of 36%. The company's bonds are rated BBB, and the cost of debt is 8%. At this rating, the firm has a probability of default of 2.30%, and the cost of bankruptcy is expected to be 30% of firm value.

a. Estimate the unlevered value of the firm.

b. Estimate the levered value of the firm, using the adjusted present value approach, at a debt ratio of 50%. At that debt ratio, the firm's bond rating will be CCC, and the probability of default will increase to 46.61%.

18. Kansas City Southern, a railroad company, had debt outstanding of $ 985 million and 40 million shares trading at $ 46.25 per share in March 1995. It earned $ 203 million in earnings before interest and taxes, and faced a marginal tax rate of 36.56%. The firm was interested in estimating its optimal leverage using the adjusted present value approach. The following table summarizes the estimated bond ratings, and probabilities of default at each level of debt from 0% to 90%.

Debt Ratio

Bond Rating

Probability of Default

0%

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