Problem 1: (20 marks)

Grant Inc is an all equity firm operating in Nova Scotia. The firm has 1,000,000 shares outstanding trading for $25 per share. Additionally, the firm plans to pay all its future earnings as cash dividends to its shareholders.

The current return on Government of Canada T-Bills is 2%, the return on the market portfolio is 10% and Grant's estimated beta is 1.20.

Part 1: Consider a world with no taxes and no bankruptcy costs:

a)What is the market value of Grant Inc? (remember 3 decimal places). (1 mark)

b)According to CAPM, what is the cost of equity for Grant? (1 mark)

c)What is the WACC for Grant? (1 mark)

d)Grant is considering borrowing $1,000,000 at 5% and using the proceeds to repurchase some shares. Briefly explain in words using the numbers as part of your decription,the impact this will have on the market value of the firm and on the WACC. (4 mark)

Part 2: Consider a world with taxes but no bankruptcy costs. The tax rate is 40%.

Assume the market value of the equity is the same as you calculated in part (a) above.

e)What would be the market value of Grant if it plans to add $1,000,000 of debt with a coupon rate of 5% to its capital structure? Debt will be sold at par value and will be used to repurchase shares. The tax rate is 40%. (1 mark)

f)What would be the cost of equity of Grant if it plans to add $1,000,000 of debt with a coupon rate of 5% to its capital structure? Debt will be sold at par value and will be used to repurchase shares. (1 mark)

g)What would be the WACC of Grant if it plans to add $1,000,000 of debt with a coupon rate of 5% to its capital structure? Debt will be sold at par value. (1 mark)

h)What is the optimal capital structure for Grant? Explain in words and state why.(6 marks)

Part 3: Consider a world with taxes and costs for the risk of financial distress. The tax rate is 40%. Assume the market value of the equity is the same as you calculated in part (a) above.

Grant is now trying to determine whether they should borrow $1,000,000 and repurchase shares

Value of debt

R_D

PV of distress costs

$0

-

-

$1,000,000

7%

$600,000

i)Now what is the value of the firm if they issue $1,000,000 in debt? (1 marks)

j)What is the optimal capital structure for Boston: $0 or $1,000,000 in debt?Explain in words supported by the numbers. (3 mark)