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Debt to Equity Ratio: Maximizing Value

If your firm has a debt issue outstanding with 7 years to maturity at 87 percent of face value paying semi-annually at 6.5%, what is the cost of debt? Assume a 35% tax rate.
Is there a debt to equity ratio that will maximize the value of the firm? Why or why not?

Solution Preview

The cost of debt is the Yield to Maturity (YTM) of the existing debt. The YTM is the discount rate that will make the present value of interest and principal equal to the price today. The interest amount is 1,000X6.5%/2=$32.5 every six months. The principal amount is $1,000 the current price is 1,000X87%=870. The periods till maturity are 7X2=14 for semi annual. The interest is an ...

Solution Summary

The solution explains how to calculate the cost of debt and the debt equity ratio that would maximize the value of the firm.