Firm XYZ currently has a capital structure of 30% debt and 70% equity. The cost

Question

Firm XYZ currently has a capital structure of 30% debt and 70% equity. The cost of debt is currently 6% and the cost of equity is 12%. The value of debt is $300 million and the value of equity is $700 million. Let the tax rate equal 34%. An investment banker tells the CFO of the company that if the firm increases its leverage ratio, the cost of debt will increase according to the following schedule 4. Percentage Equity 70% 60% 50% Percentage Cost of Debt Debt 30% 40% 50% 8% 7% 8% Assume that the cash flow of the firm may be represented as a perpetuity. Determine the WACC for each debt level Determine the value of the firm for each firm level Answer: 4 Cost of Debt Increases at Each Debt Level % Equity 70% 60% 50% Value % Debt 30% 4096 50% WACC 6% 7% 8% 12.00%| 9.59%) 13.73%| 10.09%) 15.76%) 10.52%) $1,000,000,000 $950,343,845 $911,237,078 Conclusion: OPTIMAL TO NOT increase leverage because value of firm decreases

Explanation / Answer

Rel=12% given in question
WACC=(cost of debt*wt of debt)+(cost of equity*wt of equity)
=(30%*6%*(1-34%))+(70%*12%)=9.59%
Value=300mn+700mn=1000mn

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