A firm with a normalized pretax income of $40 million, 25% tax rate, and a Total
ID: 2715391 • Letter: A
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% (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?
How would your answer change if the debt was unsecured? Specifically, what might the credit rating be under an unsecured format and how would this affect the value of the firm? Explain or provide your reasoning.
How would your answers be affected by the percentage of insider ownership of equity and what life-cycle stage the firm is in? Explain or provide your reasoning.
Explanation / Answer
A firm with a normalized pretax income of $40 million, 25% tax rate, and a Total
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