Teresa, the owner of Stack Brewery, recently met with a consultant who advised the firm that it was under-leveraged and should be recapitalized. She had always financed the firm entirely with her own funds and having feigned comprehension at their meeting, wondered exactly this could mean.

1. Briefly explain what condition(s) would be necessary to create firm value by swapping equity for debt (borrowing money against the firms assets and paying it to herself as a dividend)

Buoyed by this realization, Teresa wondered exactly how much debt to take on. A cursory search of internet resources pointed to the Static Trade-off Model, which suggested there was an optimal ratio of debt-to-equity financing which would maximize the value of the company.

2. Briefly explain the two value frictions which impact the firm in this model and describe the optimal capital structure in terms of these two concerns.

Given the challenges of applying the model (and not wanting to take on too much risk), Teresa decided to benchmark the firms target capital structure to others operating in the same industry. Using Aswath Damodarans sectoral D/E estimate of 21.42%, Teresa wondered what impact this change might have on the firms cost of equity. Stack currently has an equity beta 0.75 and faces a 15% tax rate.

3. Assuming a risk-free rate of 4% and a market risk premium of 5%, what would Stacks cost of equity capital be before and after this recapitalization?

Teresa was confused by her result in part c) and wondered whether the consultant knew anything at all about corporate finance. How could she be better off if her earnings would be both reduced by interest payments AND would face a higher discount rate?

4. Show that Teresa would have more wealth after the proposed recapitalization