1. According to M & M Proposition 1 with taxes, what is the optimal capital stru

Question

1. According to M & M Proposition 1 with taxes, what is the optimal capital structure for every firm.

2. A) Fonda Enterprise expects to generate an annual cash flow of $195 each year in perpetuity. Fonda has $800 worth of debt and a tax rate of 35%. If Fonda’s unlevered required return on assets is 10.6%, what is the value of Fondas equity?

b) If Fonda can issue debt at an interest of 8.7%, what is its cost of equity?

c) What is Fondas weighted average cost of capital (WACC)?

d) According to M & M Proposition II with taxes, what would happen if you added more debt to Fonda’s capital structure?

I. WACC would decrease.

II. WACC would stay the same.

III. WACC would increase.

IV. WACC would change, but it’s impossible to know how without more information about the company.

Explanation / Answer

1) According to MM proposition 1 Optimal capital structure exist where debt is 100%. Because it assumes interest cost is deductible and value of levered firm is summation of unlevered firm plus debt after removing tax effect.

2)a) Equity = 195/0.106 + 800*0.35 = 1839.62 +280 = 2119.62

b) Ke = 0.106 + 800/2119.62 (.106-.087)(1-.35) = 0.106 + 0.3774*0.019*0.65 = 11.066%

c) WACC = 11.066/ 2919.62*2119.62 + 8.7/2919.62*800 = 8.034 + 2.383 = 10.417%

d) WACC would decrease

Related Questions

Navigate

• Browse (All)
• Browse 1
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.