Problem 3 (32 marks)

Your best friend is in a senior position of the finance department of Teenie Tiny and you are having lunch together after a round at the golf course. The discussion gets around to the fact that Teenie Tiny will lose their tax-exempt status and your friend mentions that all the debt that the company needs will be financed using bonds with a 5 percent coupon. However, you remember that during a lecture at SMU, it was mentioned that as a company issues more and more debt, the risk for the bondholders will increase and bondholders will require coupon interest rates to increase as the amount of debt increases. You have prepared the following table to assist in answering these questions:

		Value of Debt	RD	Beta
EBIT	800,000	0	5.0%	1.392500
Tax Rate	40%	250,000	5.5%	1.483015
T-bill Rate	3.0%	500,000	6.0%	1.542274
TSX	11.0%	750,000	6.5%	1.607016
		1,000,000	7.0%	1.678038
		1,250,000	9.0%	1.756303
		1,500,000	11.0%	1.842075
		1,750,000	13.0%	1.939488
		2,000,000	15.0%	2.047619

4. Using the information from the table, calculate the value of the firm (proposition I), cost of equity, and the WACC (proposition II) each level of debt. (16 marks)

Value of Debt	rD	Beta
0	5.0%	1.392500
250,000	5.5%	1.483015
500,000	6.0%	1.542274
750,000	6.5%	1.607016
1,000,000	7.0%	1.678038
1,250,000	9.0%	1.756303
1,500,000	11.0%	1.842075
1,750,000	13.0%	1.939488
2,000,000	15.0%	2.047619