Problem #1: A firm with a normalized pretax income of $40 million, 25% tax rate,
ID: 2601961 • Letter: P
Question
Problem #1: A firm with a normalized pretax income of $40 million, 25% tax rate, and a Total Debt/Total Capital ratio of 30%, decides to undertake a capital expansion financed by new debt. The new level of debt will raise the Total Debt/Total Capital ratio to 40% (5-percentage points above its industry average). As a result, the firm's credit rating is downgraded by a full level (say for example, from A to B) despite being secured by specific assets. This credit downgrade raises the firm's Weighted Average Cost of Capital (aka Required Rate of Return) from 10% to 11.5% (a) What is the value of the firm prior to the downgraded credit rating? (b) Assuming the firm's capital expansion program will lead to a 20% in normalized pretax income what is the firm's value in the aftermath of the credit downgrade?Explanation / Answer
PART-1) Solution: $428,571,429
Working:
Details
Amount
Pretax income
40,000,000
Tax (25%)
10,000,000
Net Profit
30,000,000
WACC
0
Value of the equity
300,000,000
As given, Total Debt/Total Capital ratio of 30%
Thus, Total Equity/Total Capital ratio is 70%
Value of debt = 300,000,000 * 0.30/ 0.70 = 128,571,429
Value of firm = 300,000,000 / 0.70 = 428,571,429
PART-2) Solution: $521,739,130
Working:
Details
Amount
Pretax income
48,000,000
Tax (25%)
12,000,000
Net Profit
36,000,000
WACC
11.5%
Value of the equity
313,043,478
As given, Total Debt/Total Capital ratio of 40%
Thus, Total Equity/Total Capital ratio is 60%
Value of debt = 313,043,478* 0.40/0.60 = 208,695,652
Value of firm = 313,043,478/ 60% = 521,739,130
Details
Amount
Pretax income
40,000,000
Tax (25%)
10,000,000
Net Profit
30,000,000
WACC
0
Value of the equity
300,000,000
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