Question
You are the CFO of a major corporation and are making a decision on how much you can afford to borrow. Currently the firm has
You are the CFO of a major corporation and are making a decision on how much you can afford to borrow. Currently the firm has 15 million shares outstanding, and the market price per share is $40. The firm had also $180 million market value of debt outstanding. The company is rated BB right now, stock has a beta of 1.4 and the T-bill rate is 6% (market risk premium is 5%) Marginal tax rate of the firm is 40%. Your finance division estimated that the rating would change to a B if you borrow an additional $100million. The rate for BB ratings is now 10% and for B ratings is 11.5%.
- Given the marginal benefits and costs of debt financing do you recommend to go ahead with new borrowing?
- What is your calculation of the WACC with and without the $100 million new borrowing?
- If you decide to borrow $100 million what will be the new price per share of the company?
- Consider that you have a project that requires investment of $100 million and has expected before-tax revenues of $50 million and costs of $30 million per year forever. Is this a good project to undertake? Why or why not?
- If you are told that the cash flows from the above project in part 4. are certain, does that make a difference in your decision?
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