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Practice Problem

The following data reflect the current financial condition of the Irvine Corporation:

Value of debt (Book = Market) $ 1,000,000
Market value of equity $ 5,257,143
Sales, last 12 months $12,000,000
Variable operating costs (50% of sales) $ 6,000,000
Fixed operating costs $ 5,000,000
Tax rate, T (federal + state) 40%

At the current level of debt, the cost of debt, kd, is 8% and the cost of equity, ks, is 10.5%.
Management questions whether or not the capital structure is optimal, so the financial vice-
president has been asked to consider the possibility of issuing $1 million of additional debt
and using the proceeds to repurchase stock. It is estimated that if the leverage were increased
by raising the level of debt to $2 million, the interest rate on the new debt would rise to 9%
and ks would rise to 11.5%. The old 8% debt is senior to the new debt, and it would remain
outstanding, continue to yield 8%, and have a market value of $1 million. The firm is a zero-
growth firm, with all of its earnings paid out as dividends.

a. Should the firm increase its debt to $2 million?
b. If the firm decided to increase its level of debt to $3 million, its cost of the additional $2
million would be 12% and ks would rise to 15%. The original 8% of (old) debt would
remain outstanding, and its market value would remain at $1 million. What level of debt
should the firm choose: $1 million; $2 million; or, $3 million?
c. The market price of the firm's stock was originally $20 per share. Calculate the new
equilibrium stock prices at debt levels of $2 million and $3 million.
d. Calculate the firm's earnings per share if it uses debt of $1 million, $2 million, and $3
million. Assume that the firm pays out all of its earnings as dividends. If you find that
EPS increases with debt, does this mean that the firm should choose to increase its
debt to $3 million, or possibly higher?
e. What would happen to the value of the old bonds if the firm uses more leverage and
the old bonds are not senior to the new bonds?

SHOW ALL WORK, AND EXPLAIN FULLY.

Solution Preview

a. Should the firm increase its debt to $2 million?
<br>
<br>The original WACC is:
<br>WACC1= 8%*1,000,000 / (1,000,000+5,257,143) + 10.5%*5,257,143 / (1,000,000 +5,257,143) = 10.1%
<br>
<br>If debt is increased to $2 million, the total capital is unchanged
<br>C=1,000,000+5,257,143= 6257143
<br>new WACC is
<br>WACC2= 8%*1,000,000/6257143 + 9%*1,000,000/6257143 + 11.5%* (5,257,143 - 1,000,000) / 6257143 = 10.5%
<br>
<br>WACC2 > WACC1, the capital cost for the firm is higher, I don't recommend the increase in debt.
<br>
<br>b. If the firm decided to increase its level of debt to $3 million, its cost of the additional $2 million would ...

$2.19