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2. Hazel schools Ltd, an unlevered firm, has expected earnings before interest and taxes of $ 2 million a year. The firm's tax rate is
2. Hazel schools Ltd, an unlevered firm, has expected earnings before interest and taxes of $ 2 million a year. The firm's tax rate is 40%, and its market value V = E = $ 12 million. The stock has a beta of 1, the risk-free rate is 9%, and assumes that the market risk premium is 6%. Management is considering the use of debt; debt would be issued and used to buy back stock, and the size of the firm would remain constant. The interest rate on the debt is 12%. The firm's analysts have estimated that the present value of any bankruptcy cost is $ 8 million and that the probability of bankruptcy will increase with leverage according to the following schedule. Probability of failure 0 0.08 Value of debt 2,500,000 5,000,000 7,500,000 8,000,000 9,000,000 10,000,000 12,500,000 0.205 0.300 0.450 0.525 0.700 i. What is the company unlevered cost of equity? What is the optimal capital structure when bankruptcy costs are considered? What will the value of the firm be at this optimal capital structure? iii. 2. Hazel schools Ltd, an unlevered firm, has expected earnings before interest and taxes of $ 2 million a year. The firm's tax rate is 40%, and its market value V = E = $ 12 million. The stock has a beta of 1, the risk-free rate is 9%, and assumes that the market risk premium is 6%. Management is considering the use of debt; debt would be issued and used to buy back stock, and the size of the firm would remain constant. The interest rate on the debt is 12%. The firm's analysts have estimated that the present value of any bankruptcy cost is $ 8 million and that the probability of bankruptcy will increase with leverage according to the following schedule. Probability of failure 0 0.08 Value of debt 2,500,000 5,000,000 7,500,000 8,000,000 9,000,000 10,000,000 12,500,000 0.205 0.300 0.450 0.525 0.700 i. What is the company unlevered cost of equity? What is the optimal capital structure when bankruptcy costs are considered? What will the value of the firm be at this optimal capital structure
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