Problem 3: (28 marks) Alias Industries is currently an all-equity firm. In the coming year the firm is forecasting annual EBIT level $580,000. The firm expects no growth in the EBITs as it will pay all the earnings in cash dividends to its shareholders. As a result, the EBIT level of $580,000 will remain constant forever. The asset beta of the firm has an estimated value of 1.25. The expected return on a Government of Canada treasury bill is 2.2%, and the return on the TSX composite index is 7.6%. The firm has 260,000 shares of common stock outstanding. M&M Case I: no tax and no default risk. Assume cost of debt is 2.2%. a) What is the WACC of this all-equity financed firm? What is the value of the firm? (3 marks) b) What would be the firm's value and overall cost of capital, if the firm uses $2,400,000 (market value) debt to generate its EBITs of $580,000? Show your work. (4 marks) c) Complete the following table. In M&M case I, what level of debt is optimal? (3 marks) Ro RE WACC Value of Firm ?? ?? Value of Value of Debt Equity 0 ?? 600,000 5,880,447 1,200,000 5,280,447 1,800,000 4,680,447 2,400,000 ?? 3,000,000 3,480,447 3,600,000 2,880,447 ?? ?? 9.639% 10.484% 11.546% 2.2% ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? 14.768% 17.386% M&M Case II: Assume tax rate is 35% but no default risk. Assume cost of debt is 2.2%. d) What is the WACC of this all-equity financed firm? What is the value of the firm? (2 marks) e) What would be the firm's value and overall cost of capital, if the firm uses $2,400,000 (market value) debt in generating its EBITs of $580,000? (4 marks) f) Complete the following table. In M&M case II, what level of debt is optimal? (1pt) RO RE WACC Value of Value of Firm Debt ?? 0 4,422,291 600,000 4,632,291 1,200,000 4,842,291 1,800,000 ?? 2,400,000 5,262,291 3,000,000 Value of Equity ?? 3,822,291 3,432,291 3,042,291 ?? 2,262,291 2.2% 2.2% 2.2% 2.2% 2.2% 2.2% ?? 9.639% 10.484% 11.546% ?? 8.525% 8.139% 7.786% ?? 7.164% ?? 14.768% M&M Case III: Assume tax rate is 35% and default risk is present. As default risk is present, the borrowing rate for the firm varies with its financial leverage as indicated in the following table. Rp is the cost of debt. Value of Debt 0 600,000 1,200,000 1,800,000 2,400,000 3,000,000 3,600,000 RD 2.2% 2.5% 2.5% 3.7% 5.6% 8.3% 10.4% Beta of Equity 1.25 1.350 1.462 1.630 1.820 2.060 2.861 g) What is the WACC of this all-equity financed firm? What is the value of the firm? What is the market price per share of the firm? (3 marks) h) What would be the firm's value and overall cost of capital, if the firm uses $2,400,000 (market value) debt in generating its EBITs of $580,000? (4 marks) i) Complete the following table. (1pt) RE WACC Value of Value of Value of Ro Firm Debt Equity ?? 0 ?? 2.2% 4,469,863 600,000 3,869,863 2.5% 4,741,427 1,200,000 3,541,427 2.5% 4,833,176 1,800,000 3,033,176 3.7% ?? 2,400,000 ?? 5.6% 4,614,755 3,000,000 1,614,755 8.3% 4,357,193 3,600,000 757,193 10.4% ?? ?? 9.490% 8.434% 10.095% 7.951% 11.002% 7.800% ?? ?? 13.324% 8.169% 17.649% 8.652% j) Draw a graph of financial leverage against firm value. Show leverage (D/E) on the x-axis and firm value on the y-axis. You can draw this graph by hand, Excel not required. (2pt) k) In M&M Case III, what level of debt is optimal? (1pt) Problem 3: (28 marks) Alias Industries is currently an all-equity firm. In the coming year the firm is forecasting annual EBIT level $580,000. The firm expects no growth in the EBITs as it will pay all the earnings in cash dividends to its shareholders. As a result, the EBIT level of $580,000 will remain constant forever. The asset beta of the firm has an estimated value of 1.25. The expected return on a Government of Canada treasury bill is 2.2%, and the return on the TSX composite index is 7.6%. The firm has 260,000 shares of common stock outstanding. M&M Case I: no tax and no default risk. Assume cost of debt is 2.2%. a) What is the WACC of this all-equity financed firm? What is the value of the firm? (3 marks) b) What would be the firm's value and overall cost of capital, if the firm uses $2,400,000 (market value) debt to generate its EBITs of $580,000? Show your work. (4 marks) c) Complete the following table. In M&M case I, what level of debt is optimal? (3 marks) Ro RE WACC Value of Firm ?? ?? Value of Value of Debt Equity 0 ?? 600,000 5,880,447 1,200,000 5,280,447 1,800,000 4,680,447 2,400,000 ?? 3,000,000 3,480,447 3,600,000 2,880,447 ?? ?? 9.639% 10.484% 11.546% 2.2% ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? 14.768% 17.386% M&M Case II: Assume tax rate is 35% but no default risk. Assume cost of debt is 2.2%. d) What is the WACC of this all-equity financed firm? What is the value of the firm? (2 marks) e) What would be the firm's value and overall cost of capital, if the firm uses $2,400,000 (market value) debt in generating its EBITs of $580,000? (4 marks) f) Complete the following table. In M&M case II, what level of debt is optimal? (1pt) RO RE WACC Value of Value of Firm Debt ?? 0 4,422,291 600,000 4,632,291 1,200,000 4,842,291 1,800,000 ?? 2,400,000 5,262,291 3,000,000 Value of Equity ?? 3,822,291 3,432,291 3,042,291 ?? 2,262,291 2.2% 2.2% 2.2% 2.2% 2.2% 2.2% ?? 9.639% 10.484% 11.546% ?? 8.525% 8.139% 7.786% ?? 7.164% ?? 14.768% M&M Case III: Assume tax rate is 35% and default risk is present. As default risk is present, the borrowing rate for the firm varies with its financial leverage as indicated in the following table. Rp is the cost of debt. Value of Debt 0 600,000 1,200,000 1,800,000 2,400,000 3,000,000 3,600,000 RD 2.2% 2.5% 2.5% 3.7% 5.6% 8.3% 10.4% Beta of Equity 1.25 1.350 1.462 1.630 1.820 2.060 2.861 g) What is the WACC of this all-equity financed firm? What is the value of the firm? What is the market price per share of the firm? (3 marks) h) What would be the firm's value and overall cost of capital, if the firm uses $2,400,000 (market value) debt in generating its EBITs of $580,000? (4 marks) i) Complete the following table. (1pt) RE WACC Value of Value of Value of Ro Firm Debt Equity ?? 0 ?? 2.2% 4,469,863 600,000 3,869,863 2.5% 4,741,427 1,200,000 3,541,427 2.5% 4,833,176 1,800,000 3,033,176 3.7% ?? 2,400,000 ?? 5.6% 4,614,755 3,000,000 1,614,755 8.3% 4,357,193 3,600,000 757,193 10.4% ?? ?? 9.490% 8.434% 10.095% 7.951% 11.002% 7.800% ?? ?? 13.324% 8.169% 17.649% 8.652% j) Draw a graph of financial leverage against firm value. Show leverage (D/E) on the x-axis and firm value on the y-axis. You can draw this graph by hand, Excel not required. (2pt) k) In M&M Case III, what level of debt is optimal? (1pt)