7. Capital structure theory Aa Aa As a firm takes on more debt, its probability

Question

7. Capital structure theory Aa Aa As a firm takes on more debt, its probability of bankruptcy faces a Other factors hekd constant, a firm whose earmings are relatively volatlie should use chance of bankruptcy. Therefore, when other factors are held constant, a firm whose eamings are relativey volatle debt than a more stable frm, When bankruptcy costs become more important, they the tax benefits of debt. General Forge and foundry Corporation currently has no debt in ts capital structure, but it is considering using some debt and reducing outstanding equity. The firm's unlevered beta is 1.25, and its cost of equity is 13.50% Because the firm has no dett in ks capital structure, es weighted average cost of capital CwACC) elso equals 13.50%. Th General Forge's marginal tax rate 35%. its e nsk-free rate of interest (nr) is 3.5%, and the market risk premium (RD) is 8%.

Explanation / Answer

As firm takes on more debt, its probability of bankruptcy increases. Other factors held constant, a firm whose earnings are relatively volatile faces a higher chance of bankruptcy. Therefore, when other factors are held constant, a firm whose earnings are relatively volatile should use less debt than a more stable firm. When bankruptcy costs become more important, they surpass the tax benefits of debt.

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