Question
Need help with question B Nadir, an unlevered firm, has expected earnings before interest and taxes of $2 million per year. Nadir's tax rate is
Need help with question B
Nadir, an unlevered firm, has expected earnings before interest and taxes of $2 million per year. Nadir's tax rate is 40 percent, and the market value is V = E = $12 million. The stock has a beta of 1, and the risk-free rate is 9 percent. [Assume that E(Rm) -Rf= 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 default free interest rate on debt is 12 percent. Because interest expense is tax-deductible, the value of the firm would tend to increase as debt is added to the capital structure, but there would be an offset in the form of the rising cost of bankruptcy. The firm's analysts have estimated approximately that the present value of any bankruptcy cost is $8millionand the probability of bankruptcy will increase with leverage according to the following schedule:
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