Morrison Medical Inc., an all-equity firm, has earnings before interest and taxes of $950,000, an un-levered beta of .80 and a tax rate = 35%. In the market, you observe that Government T-bills are being sold to yield 2% and the S&P/TSX Composite Index is expected to yield 9%. Assume a world with taxes and a cost for the risk of default. All general M&M assumptions apply. You have also been provided the following information: Value of Debt Cost of Debt (Rd) Beta PV of Financial Distress Costs $ 0 - .80 0 $ 5,000,000 5.5% ? $800,000 $ 7,000,000 7.0% 2 ? What is the market value of the firm? What is the market value of the firm and the market value of the equity if they issue $5,000,000 in debt with a coupon rate of 4.5% and use the proceeds to repurchase shares? What is the new cost of equity?
Risk and return
Before understanding the concept of Risk and Return in Financial Management, understanding the two-concept Risk and return individually is necessary.
Capital Asset Pricing Model
Capital asset pricing model, also known as CAPM, shows the relationship between the expected return of the investment and the market at risk. This concept is basically used particularly in the case of stocks or shares. It is also used across finance for pricing assets that have higher risk identity and for evaluating the expected returns for the assets given the risk of those assets and also the cost of capital.
Morrison Medical Inc., an all-equity firm, has earnings before interest and taxes of $950,000, an un-levered beta of .80 and a tax rate = 35%. In the market, you observe that Government T-bills are being sold to yield 2% and the S&P/TSX Composite Index is expected to yield 9%. Assume a world with taxes and a cost for the risk of default. All general M&M assumptions apply. You have also been provided the following information:
| Value of Debt | Cost of Debt (Rd) | Beta | PV of Financial Distress Costs |
| $ 0 | - | .80 | 0 |
| $ 5,000,000 | 5.5% | ? | $800,000 |
| $ 7,000,000 | 7.0% | 2 | ? |
- What is the market value of the firm?
- What is the market value of the firm and the market value of the equity if they issue $5,000,000 in debt with a coupon rate of 4.5% and use the proceeds to repurchase shares?
- What is the new
cost of equity ? - According to
CAPM , what is the new beta? - What is the market value of the firm if the firm issues $7,000,000 in debt?
- What would be the PV of financial distress costs if the firm issues $7,000,000 in debt?
- What is the optimal level of debt $0, $5,000,000 or $7,000,000? Explain.
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