Capital structure theory, Financial Management

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Capital structure theory:

Use the following information to answer the questions:

Case I: Capital structure theory (no tax)

Case II: Capital structure theory (corporate tax)

WACC : 10%

Debt-to-firm value(D/V) : 50%

Cost of debt : 6%

EBIT : $40 million

Tax rate : 50%

Unlevered cost of capital : 10%

a. In Case I, when the debt-to-firm value decreases to 40%, figure out the new WACC. And does the cost of equity increase or decrease?

b. In Case II, when the debt is zero, figure out the firm's value based on the assumption that EBIT is constant forever. Again, when the debt increases to $30mil., figure out the firm's value?

c. In Case II, when the debt increases to $30mil., does the WACC increase or decrease or stay the same? And does the cost of equity increase or decrease?


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