Question

As a firm takes on more debt, its probability of bankruptcy ____________ (options: increase or decrease). Other factors held constant, a firm whose earnings are relatively volatile faces a __________ (options: greater or lower) chance of bankruptcy. Therefore, when other factors are held constant, a firm whose earnings are relatively volatile should use ________ (options: more or less) debt than a more stable firm. When bankruptcy costs become more important, they ________ the tax benefits of debt.

General Forge and Foundry Corporation 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 1.2, and its cost of equity is 12.40%. Because the firm has no debt in its capital structure, its weighted average cost of capital (WACC) also equals 12.40%. The risk-free rate of interest (rRFrRF) is 4%, and the market risk premium (RPMRPM) is 7%. General Forge’s marginal tax rate is 25%.

General Forge 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.

D/Cap Ratio	E/Cap Ratio	D/E Ratio	Bond Rating	Before-Tax Cost of Debt (rdrd)	Levered Beta (b)	Cost of Equity (rsrs)	WACC
0.0	1.0	0.00	—	—	1.2	12.40%	12.40%
0.2	0.8	0.25	A	7.2%		13.975%	12.260%
0.4	0.6	0.67	BBB	7.7%	1.800	16.600%
0.6	0.4	1.50	BB	8.9%	2.550		12.745%
0.8	0.2		C	11.9%	4.800	37.600%

Answer 1

As a firm takes on more debt, its probability of bankruptcy increases. Other factors held constant, a firm whose earnings are relatively volatile faces a greater 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 offset the tax benefits of debt. (Explanation: Debt payments are fixed unlike dividend payouts which are at the discretion of company performance and management decision. Therefore, debt payments are affected more by volatile earnings.)

D/Cap Ratio	E/Cap Ratio	D/E Ratio	Bond Rating	Before-Tax Cost of Debt (rdrd)	Levered Beta (b)	Cost of Equity (rsrs)	WACC
0	1	0	—	—	1.2	12.40%	12.40%
0.2	0.8	0.25	A	7.20%	1.43	13.98%	12.26%
0.4	0.6	0.67	BBB	7.70%	1.8	16.60%	12.27%
0.6	0.4	1.5	BB	8.90%	2.55	21.85%	12.75%
0.8	0.2	4.0	C	11.90%	4.8	37.60%	14.66%

Formulas:

Levered beta = (cost of equity - risk-free rate)/market risk premium

WACC = (weight of debt*cost of debt*(1-Tax rate)) + (weight of equity*cost of equity)

Cost of equity = risk-free rate + beta*market risk premium

AB E/Cap Ratio 111 D/Cap Ratio 1120 113 0.2 114 0.4 115 0.6 116 0.8 D/E Ratio Bond Rating =A112/B112 =A113/B113 A =A114/B114 BBB =A115/B115BB =A116/8116 C Before-Tax Cost of Debt (rdrd) Levered Beta (b) 1.2 0.072 =1G113-4%)/7% 0.077 1.8 0.089 2.55 0.119 4.8 Cost of Equity (rsrs) 0.124 0.13975 0.166 =4%+F115*7%) 0.376 WACC 0.124 0.1226 =(G114*B114)+(E114*(1-25%)*A114) 0.12745 =(G116*B116)+(E116*(1-25%)*A116) 0.6 0.2