QUESTION 1

BMC Inc. currently has $1,000,000 of 8% coupon bonds and 40,000 common shares outstanding. The tax rate is 40%. The firm is considering a large investment of $1,500,000 in a new project. The following options are feasible for raising this capital: Option 1: Sell $1,500,000 worth of common stock at $50 per share. Option 2: Issue $1,000,000 worth of 6% coupon bonds with a 20-year maturity, in addition to $500,000 worth of common stock at $50 per share.

a) Calculate the EBIT indifference point for the 2 options.

b) What is the EPS at the EBIT indifference point? At EBIT levels above the EBIT indifference point, which plan is better?

QUESTION 2

B&B Inc. has a book value of debt of $500,000. The market value of debt is $550,000. Its pre-tax cost of debt is 10%, and its beta is equal to 2. The tax rate is 40%. The firm has an annual EBIT of $200,000. In the market, you observe that T-bills are being sold to yield 1%, and the S&P/TSX Composite Index is expected to yield 6%.

What is B&Bs weighted average cost of capital? Assume there is no cost of financial distress.

QUESTION 3

An unlevered firm, CEA Inc., has 160,000 common shares issued and outstanding. It has a perpetual constant EBIT of $800,000 and an unlevered beta of 1.5. The firm has corporate tax rate of 40%. The market risk premium is 8% and the risk- free rate is 3%. Assume a world of taxes and costs of financial distress.

a) Calculate the value of the firm.

b) Calculate the WACC for the firm.

c) What is the value of a share in the company and what is the EPS?

d) If the firm issues $1,000,000 of bonds with a coupon rate of 10%, and now the beta of the levered firm is 1.85, what is the value of the firm?

e) What is the WACC for the firm with its new capital structure?