A firm with a normalized pretax income of $40 million, 25% tax rate, and a Total

Question

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%

What is the value of the firm prior to the downgraded credit rating?

Assuming the firm’s capital expansion program will lead to a 20% increase in normalized pretax income what is the firm’s value in the aftermath of the credit downgrade?

Explanation / Answer

Particulars Prior to Credit Downgrade After Credit Downgrade Profit Before Tax 40 48 Less: Taxes at 25% 10 12 Profit After Tax 30 36 Debt Equity Ratio 30% 40% WACC 10% 11.50% Equity 300 300 Debt 90 120 TOTAL 390 420 Value of Firm 390 420

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