Question

7. Capital structure theory Aa Aa E As a firm takes on more debt, its probability of bankruptcy | faces a chance of bankruptcy. Therefore, when debt than a more stable firm. When bankruptcy d Other factors held constant, a firm whose earnings are relatively volatile decreases are held constant, a firm whose earnings are relatively volatile should use increases hore important, they the tax benefits of debt. Green Goose Automation Company currently has no debt in its capital structure, but it is considering using some debt and reducing its outstanding equity. The firm's unlevered beta is 1.1, and its cost of equity is 10.70%. Because the firm has no debt in its capital structure, its weighted average cost of capital (WACC) also equals 10.70%. The risk-free rate of interest (rRF) is 3%, and the market risk premium (RP) is 7%. Green Goose's marginal tax rate is 35%. Green Goose is examining how different levels of debt will affect its costs of debt and equity, as well as its WACC. The firm has collected the financial information that follows to analyze its weighted average cost of capital (WACC). Complete the following table. E/A Ratio Bond Rating Before-Tax Cost of Debt (4) Levered Beta (b) WACC 1.0 - 1.1 D/A Ratio 0.0 0.2 0.4 0.6 0.8 D/E Ratio 0.00 0.25 0.67 Cost of Equity (rs) 10.70% 11.96% 14.06% 10.70% 10.50% 0.8 BBB 0.6 0.4 0.2 7.2% 7.7% 8.9% 11.9% 1.50 BB 1.58 2.17 3.96 10.75% - C 30.72%

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ke - Microsoft Excel (Product Activation Failed) Review File Home Insert Page Layout Formulas Data View Add-Ins Σ AutoSum - Cut A A Wrap Text Calibri 11 General Copy Fill $ % Paste в IU* +.0 .00 Conditional Format Cell Insert Delete Format Sort & Find & aMerge & Center .00 0 Format Painter Clear Filter Select Formatting as Table Styles Editing Clipboard Font Alignment Number Styles Cells fx FU424 FZ GD FS FT FU EV FW FX FY GA GB GC GE GF GG GH 415 416 417 As firm takes on more debt, the probability of bankruptcy increases. Other factors held constant, a firm whose earnings are relatively volatile faces a greater chances of bankruptcy 418 Therefore, when other factors are held constant, a firm whose earnings are relatively volatile should use less debt than a more stable firm 419 420 when bankruptcy costs become more important, they reduce the tax benefits of debt 421 422 423 424 425 426 427 428 429 430 431 432 433 434 UTILITY, SHARPE, beta YIELD bond portfolio RESI e CONVEXITY DGM beta LEASING PV, FV, ANNUITY DIR right clean КE САРМ port future INDEX I INTL CAP BUD cap stru WACC II Rea erences: CF670 120% WA 06:06 ENG 23-11-2019

ke - Microsoft Excel (Product Activation Failed) Review File Home Insert Page Layout Formulas Data View Add-Ins E AutoSum - Cut A A Wrap Text Calibri 11 General ECopy Fill Merge & Center Insert Delete Format Paste B I U $ % , +.0 .00 .00 0 Conditional Format Cell Sort & Find & Format Painter Clear Filter Select Formatting as Table Styles Editing Clipboard Font Alignment Number Styles Cells fox GA374 FZ FX GD FS FT FU EV EW FY GA GB GC GE GF GG GH 374 SEE TABLE GO LINE BY LINE : I HAVE EXPLAINED ALL ANSWERS 375 376 ANSWER OF SECOND LINE = LEVERED BETA LEVERED BETA = UNLEVERED BETA ( 1 + (1-t) (D/E) LEVERED BETA = 1.1*(1 + (1-0.35)(0.25)) 377 378 1.28 379 ANSWER OF THIRD LINE = WACC WACC ke*(We) kd(1-t)*(Wd) 380 WACC 14.06%(1/1.67) + 7.70%(1-0.35)(0.67/1.67)= 10.43% 381 ANSWER OF 4TH LINE = ke 382 WACC ke*(We) kd(1-t)*(Wd) 383 ke(1/2.5) 8.90%(1-0.35) (1.5/2.5) 384 10.75% 10.75% ke(1/2.5)3.471% 385 ke (1/2.5) 7.279% 18.20% 386 ANSWER OF 5TH LINE = D/E 387 D/E 0.8/0.2 = 4 388 4 389 ANSWER OF 5TH LINE = WACC WACC ke*(We) kd(1-t)*(Wd) WACC 30.72%(0.2) +11.9%(1-0.35)(0.8) WACC 12.332% = 390 391 392 12.33% 393 204 UTILITY, SHARPE, beta YIELD bond portfolio CONVEXITY DGM beta LEASING PV, FV, ANNUITY DIR right clean КE САРМ port future INDEX RESI eI INTL CAP BUD cap stru WACC II Rea 120% erences: CF493 WA 06:06 ENG 23-11-2019