3. Assume that your company currently has the following characteristics: D/V = .20

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3. Assume that your company currently has the following characteristics:
D/V = .20 Rf = 3%
E/V = .80 Market Risk Premium = 5.0%
Beta = 1.20 tax rate = 30%
Current EBIT = 3,000,000 Interest = 630,000
In addition, you obtain the following data from a rating agency:
For smaller and riskier firms:
If interest coverage ratio is
greater than
≤ to
Rating is
Spread is
0.50
0.799
C
10.50%
0.80
1.249
CC
9.50%
1.25
1.499
CCC
8.75%
1.50
1.999
B-
6.75%
2.00
2.499
B
6.00%
2.50
2.999
B+
5.50%
3.00
3.499
BB
4.75%
3.50
3.999
BB+
3.75%
4.00
4.499
BBB
2.50%
4.50
5.999
A-
1.65%
6.00
7.499
A
1.40%
A. Estimate the current cost of capital for your company.
Assume a financial advisor has suggested to management that it could increase ROE by increasing leverage to D/V = .75 and E/V = .25. Interest expense would increase to approximately $2 million and operating earnings would not be materially affected. This is a critical thinking question. Evaluate and carefully explain whether you think this is a good or bad idea. Discuss the potential pros and cons of such a suggestion? Be sure to include appropriate calculations to support your answer.