Question
You have been hired as a management consultant by AD Corporation to evaluate whether it has an appropriate amount of debt (the company is worried
You have been hired as a management consultant by AD Corporation to evaluate whether it has an appropriate amount of debt (the company is worried about a leveraged buyout). You have collected the following information on ADs current position:
- There are 100,000 shares outstanding at $20/share. The stock has a beta of 1.15.
- The company has $500,000 in long-term debt outstanding and is currently rated BBB. The current market interest rate is 10% on BBB bonds and 6% on treasury bonds.
- The companys marginal tax rate is 40%.
- Equity risk premium is 5.5%.
You proceed to collect the data on what increasing debt will do to the companys ratings:
Additional debt | New rating | Interest rate |
$500,000 | BB | 10.5 |
$1,000,000 | B | 11.5 |
$1,500,000 | B- | 13.5 |
$2,000,000 | C | 15 |
How much additional debt should the company take on assuming that the cash from new debt would not be used to buyback shares but to invest in projects with similar risk as the rest of the firm? Assuming that these projects are zero NPV projects.
(Please calculate the WACC for each scenario and show solution with formula.)
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