Consider a 25/75 debt/equity financing case for your firm. Your firm will produce a before-tax…

Consider a 25/75 debt/equity financing case for your firm. Your firm will produce a before-tax return of $280, the investment costs $200, the tax rate is 30%, the overall opportunity cost of capital (in other taxable projects) is 12%, and when the firm is 25% debt-financed, debt must offer an expected rate of return of 8%. (If you think of your opportunity cost of capital as the best your firm can achieve elsewhere, then these cost-of-capital numbers are your before-tax costs of capital from other projects before they would be taxed, too. If you think of your opportunity cost of capital as

┬╗Consider a 25/75 debt/equity financing case for your firm. Your firm will produce a before-tax return of $280, the investment costs $200, the tax rate is 30%, the overall opportunity cost of capital (in other taxable projects) is 12%, and when the firm is 25% debt-financed, debt must offer an expected rate of return of 8%. (If you think of your opportunity cost of capital as the best your firm can achieve elsewhere, then these cost-of-capital numbers are your before-tax costs of capital from other projects before they would be taxed, too. If you think of your opportunity cost of capital as provided by your investors, who [like you] are also taxed, then it is the rate of return before their personal income taxes. The cost of capital for your personal investors is the subject of the next chapter.) First compute the WACC, then compute the debt as 25% of the WACC value, and show how the APV yields the same result. Consider financing your firm with $100 debt: The before-tax return is $280, the investment cost is $200, the tax rate is 30%, the overall cost of capital is 12%, and this debt must offer an expected rate of return of 8.7%. (These are again before-tax opportunity rates of return.) First compute the APV, then compute the capital structure in ratios, and finally show that the WACC yields the same result.

┬╗