You are given a choice of taking the simple interest on 100,000 invested for 2 years

You are the financial vice-president of the XYZ Corporation. Management is questioning whether or not the existing capital structure is optimal so you have been asked to consider the possibility of issuing $1 million of additional debt and using the proceeds to repurchase stock. The following data reflect the current fmancial conditions of the XYZ 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-plus-state) 40%

At the current level of debt, the cost of debt, kd, is 8 percent and the cost of equity, ke, is 10.5 percent. It is estimated that if the leverage were increased by raising the level of debt to $2 million, the interest rate on new debt would rise to 9 percent and the cost of equity would rise to 11.5 percent. The old 8 percent debt is senior to the new debt, and it would remain outstanding, continue to yield 8 percent, 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?

Hint: Find the new value of the firm using the following equation: V = D + E

= D + [{(EBIT - Int) (1 - T)}/ke] and compare it with the existing value of the firm.

b. If the firm decided to increase its level of debt to $3 million, its cost of the additional $2 million of debt would be 12 percent and ke would rise to 15 percent. The originalS percent of debt would again remain outstanding, and its market value would remain $1million. 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.

(Hint: Shares outstanding = Value of Equity I Price. Note that the repurchase price is the equilibrium price that would prevail after the repurchase transaction. Original shareholders would sell only at a price which incorporated any increased value resulting from the repurchase.)

d. What would happen to the value of the old bonds if XYZ Corporation uses more leverage and the old bonds are not senior to the new bonds? What would happen to the value of equity? Explain.

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