ABC inc. is considering changing its capital structure. The firm currently has no debt (unlevered)...
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ABC inc. is considering changing its capital structure. The firm currently has no debt (unlevered) and preferred stock, but it would like to add some debt to take advantage of low interest rates and the tax shield. The following is the estimate of before tax cost of debt for the firm under capital structure plan L.
Wd
(Market debt to value ratio)
Ws
(Market equity to value ratio)
Rd
(Before tax cost of debt)
Capital structure plan L
0.3
0.7
10%
The firm estimates cost of common equity, Rs, with CAPM. Risk free rate is 6%, market return is 10% and tax rate is 35%. The firms unlevered beta is 1.0.
a) What is the weighted average cost of capital (WACC) under the capital structure plan L?
b) Assume that ABC inc. is a zero-growth firm and pays all its earnings as dividends. The firms EBIT is $50 million, and its tax rate is 35%. What is the firms total value under the capital structure plan L?
c) What is the WACC under current capital structure (e.g., with zero leverage)?
d) CEO wants to know what are the benefits and costs of debt use (leverage)? Answer the CEOs question with 1-3 sentences. (You do not need to do any calculations)
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