ABC Company currently has $300 million debt and $700 million equity (market value). You are hired by the company to analyze whether increasing the debt ratio to 40% (the proceeds of borrowing will be used to buy back stocks) would increase the firm value. Assume the debt level will be permanent for the firm. You collected the following information:

- The company faces a marginal tax rate of 30%. The risk free rate is 4.5%.

- The firms cost of debt is tied to the credit rating (Exhibit 2). The firms current credit rating is A-. The credit rating is determined by interest coverage ratio (Exhibit 1). Your company is expected to maintain EBIT of $60 million.

- The cost of bankruptcy of the firm is expected to be 30%. The probability of default is tied to credit rating (Exhibit 2). You decide to use the adjusted present value method to make the decision. To do so you are supposed to answer the following questions:

• 1. At the 40% debt ratio, what is the present value of debts tax shield?

• 2. At the 40% debt ratio, what is the present value of bankruptcy cost?

• 3. What is the firm value corresponding to a 40% debt ratio?

• 4. Should the firm increase the debt ratio to 40% based on your analysis?

PLEASE SHOW ALL WORK!!!! NO EXCEL OR TABLES PLEASE!!

Exhibit 1 Exhibit 2 Default Spread (Basis points) If INT Cov> 8.50 Rating AAA AA Rating AAA 6.5 AA 5.5 INT Cov 8.50 Rating AAA AA Rating AAA 6.5 AA 5.5 INT Cov