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M&M and Taxes In the previous question, suppose the corporate tax rate is 35 percent. What is EBIT in this case? What is the WACC? Explain. Calculating WACC Nopay Industries has a debt-equity ratio of 2. Its WACC is 11 percent, and its cost of debt is 11 percent. The corporate tax rate is 35 percent.

a. What is Nopay's cost of equity capital?

b. What is Nopay's unlevered cost of equity capital?

c. What would the cost of equity be if the debt-equity ratio were 1.5? What if it were 1.0? What if it were zero?

Calculating WACC Molly Corp. has no debt but can borrow at 9 percent. The firm's WACC is currently 15 percent, and the tax rate is 35 percent.

a. What is Molly's cost of equity?

b. If the firm converts to 25 percent debt, what will its cost of equity be?

c. If the firm converts to 50 percent debt, what will its cost of equity be?

M&M and Taxes Maria & Co. expects its EBIT to be $80,000 every year forever. The firm can borrow at 14 percent. Maria currently has no debt, and its cost of equity is 25 percent. If the tax rate is 35 percent, what is the value of the firm? What will the value be if Maria borrows $50,000 and uses the proceeds to repurchase shares?

M&M and Taxes In Problem 14, what is the cost of equity after recapitalization? What is the WACC? What are the implications for the firm's capital structure decision?

M&M Bruin Manufacturing has an expected EBIT of $26,000 in perpetuity, a tax rate of 35 percent, and a debt-equity ratio of .60. The firm has $60,000 in outstanding debt at an interest rate of 8 percent, and its WACC is 12 percent. What is the value of the firm according to M&M Proposition I with taxes? Should Bruin change its debt-equity ratio if the goal is to maximize the value of the firm? Explain.

Firm Value Bellevue Corporation expects an EBIT of $6,000 every year forever. Bellevue currently has no debt, and its cost of equity is 16 percent. The firm can borrow at 10 percent. If the corporate tax rate is 35 percent, what is the value of the firm? What will the value be if Bellevue converts to 50 percent debt? To 100 percent debt?

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

VI. Cost of Capital and Long-Term Financial Policy

17. Financial Leverage and Capital Structure Policy

© The McGraw-Hill Companies, 2002

CHAPTER 17 Financial Leverage and Capital Structure Policy

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