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Debt financing in the firm

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You have the following data on Joeâ??s Corporation:

EBIT: $1,000,000
Tax rate: 40%
Cost of Equity: 10% (before borrowing) 12% (after borrowing)

Joeâ??s is a zero growth firm, and is currently financed entirely with equity (in other words, it currently has no debt).

One of the corporate officers has suggested that since interest rates are so low, Joe might be better off if he borrowed some money and used it to buy back stock, thereby making use of debt financing in the firm. He presents the following data in his analysis:

Amount of debt proposed: $2,000,000
Interest rate: 6%
Cost of equity after the proposal is adopted: 12%

Joe has come to you for advice. Prepare an analysis for him that indicates whether or not the proposal should be accepted.

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Solution Preview

We find the value of the firm without debt and with debt in order to make the decision. If the value after debt is higher, the proposal should be accepted
Without debt, the value of firm is calculated as = EBIT X ...

Solution Summary

The solution explains how to determine if the firm should go for debt financing

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