Answer Happy

Firm ABC is evaluating the optimal amount of debt that it should take. You are the CFO of firm ABC and have collected the following information on the firm's current position: (a) There are 100,000 shares outstanding and stock price is $30/share. The stock has a beta of 1.2. Equity market risk premium (Market return-Rh) is 5%. The cash flow to be generated by the firm will grow at the rate of 4% per year forever. (b) The company has $300,000 in long-term debt outstanding and is currently rated 'BBB'. The current pre-tax interest rate is 10% on BBB bonds and 6% on T.Bonds. If the firm determines to issue new debt, capital obtained from the newly issued debt will be used to buy back stocks so that the size of the firm would not change. (c) The company's marginal tax rate is 40%. The current debt ratio based on the information shown above is: 300,000/(300,000+100,000*30)=9.09%. The firm is thinking about whether to increase the debt ratio to 16.67%, 23.08%, 28.57%, or 33.33%. You proceed to collect the data on how increasing debt ratio will affect ABC's credit rating: Debt ratio Credit Rating Pre-tax Cost of Debt BBB 10.00% 9.09% (current) 16.67% 23.08% 28.57% 33.33% BB IB 10.50% 11.00% 11.25% 12.00% B- C REQUIRED Q1.1 Use the cost of capital approach and the information shown in the table above to determine under which debt ratio (9.09%, 16.67%, 23.08%, 28.57%, or 33.33%) the value of firm ABC will be maximized. [40 Marks] (hint: calculate cost of equity, after-tax cost of debt, and cost of capital for each level of debt ratio, and then determine the optimal debt ratio among the 5 choices given.) Q1.2 Use the incremental approach to calculate what will the stock price per share be after ABC moves to the optimal debt ratio. [30 Marks] Q1.3 What are the limitations of applying the cost of capital approach in analysing the optimal level of debt that a firm should take? [10 Marks]