Trade-Off Theory. Smoke and Mirrors currently has EBIT of $25,000 and is all-equity- financed. EBIT is expected to stay at this level indefinitely. The firm pays corporate taxes equal to 35% of taxable income. The discount rate for the firm’s projects is 10%.(LO3) a. What is the market value of the firm?

b. Now assume the firm issues $50,000 of debt paying interest of 6% per year, using the proceeds to retire equity. The debt is expected to be permanent. What will happen to the total value of the firm (debt plus equity)?

c. Recompute your answer to (b) under the following assumptions: The debt issue raises the probability of bankruptcy. The firm has a 30% chance of going bankrupt after 3 years. If it does go bankrupt, it will incur bankruptcy costs of $200,000. The discount rate is 10%. Should the firm issue the debt?

a. What is the market value of the firm?

b. Now assume the firm issues $50,000 of debt paying interest of 6% per year, using the proceeds to retire equity. The debt is expected to be permanent. What will happen to the total value of the firm (debt plus equity)?

c. Recompute your answer to (b) under the following assumptions: The debt issue raises the probability of bankruptcy. The firm has a 30% chance of going bankrupt after 3 years. If it does go bankrupt, it will incur bankruptcy costs of $200,000. The discount rate is 10%. Should the firm issue the debt?

Explanation:

the firm's current value = [EBIT x (1 - tax rate)] / WACC = [$25,000 x 0.65] / 10% = $162,500

firm's new WACC = ($112,500/$162,500 x 10%) + ($50,000/$162,500 x 6% x 0.65) = 6.92% + 1.2% = 8.12%

the firm's new value = [$25,000 x 0.65] / 8.12% = $200,123

expected cost of bankruptcy = (30% x $200,000) / 1.1³ = $45,079

firm's total value is still $200,123, but the stockholders' equity has been reduced from ($200,123 - $50,000 = $150,123) to $150,123 - $45,079 = $105,044

the gain from issuing debt will be eliminated due to the risk of bankruptcy, before equity had risen from $112,500 to $150,123, but now it decreases to $105,044.

answer; correct answer is investing activity;

answer; the coefficient of determination;