A consultant has collected the following information regarding Hobbit Manufactur

Question

A consultant has collected the following information regarding Hobbit Manufacturing:

Operating income (EBIT) $600 million, Interest expense $0, Tax rate 35%, Debt $0, Cost of equity 7%, WACC 7% . The company has no growth opportunities (g = 0), so the company pays out all of its earnings as dividends . Hobbit can borrow money at a pre-tax rate of 6%. The consultant believes that if the company moves to a capital structure consisting of 30% debt and 70% equity (based on market values), which would require taking on debt in the amount of $1,728.21 million, that the cost of equity will increase to 8% and the pre-tax cost of debt will remain at 6%, but the value of the firm will rise.   Is the consultant correct? If the company makes this change, what will be the increase in total market value for the firm?

Explanation / Answer

Value of the firm=EBIT/WACC=600/0.07 (A) 8571.429 In the new structure Debt(B) 1728.21 Interest payment=0.06*B

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