solution

Consider a project whose EBIT, each period and for ever, is either $50M or $100M. There is a 20% chance that EBIT is $50M each period. The project is financed in part by an interest-only perpetuity with face value D with an interest rate of 7%. The rest of the financing is equity. Investment is $20M each period, as is depreciation. The company pays t = 30% in income taxes. Equity holders require a 10% return when D = 0.

1. What is the value of the corporation when D = 0? (In other words, what is V U ?)
2. What is the highest possible face value (Dmax) of the perpetuity such that the perpetuity is risk free?
3. For face values D ranging from 0 to Dmax plot on one chart the expected return on equity and WACC.
4. Produce the same graph for the case where t = 0. What is the main qualitative difference between this chart and the chart you plotted in the previous step?
5. Assume now that t is back to 30% and that the corporation has the option to go bankrupt. Expected costs associated with bankuptcy are 0.0005 (D)2. This
includes any and all loss in debt tax shield. Plot the corporation’s value against DE .
6. What is the corporation’s optimal capital structure (approximately)?