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As a firm takes on more debt, its probability of bankruptcy . Othe

As a firm takes on more debt, its probability of bankruptcy . Other factors held constant, a firm whose earnings are relative

As a firm takes on more debt, its probability of bankruptcy . Other factors held constant, a firm whose earnings are relatively volatile faces a chance of bankruptcy. Therefore, when other factors are held constant, a firm whose earnings are relatively volatile should use debt capital than a firm whose earnings are more stable. When bankruptcy costs become more important, they the tax benefits of debt. General Forge and Foundry Corporation currently has no debt in its capital structure, but it is considering adding some debt and reducing the percentage of outstanding equity in its capital structure. The firm's current (unlevered) beta is 1.25, and its cost of equity is 12.25. Because the firm has no debt in its capital structure, its weighted average cost of capital (WACC) also equals 12.25. The risk-free rate of interest (PRF) is 3.5%, and the market risk premium (RPM) is 7%. General Forge's marginal tax rate is 35%. General Forge is examining how different levels of debt will affect its costs of debt and equity, as well as its WACC. The firm has collected the financial information that follows to analyze its WACC. Complete the following table. D/A Ratio 0.0 Bond Rating Before-Tax cost of Debt E/A Ratio 1.0 0.8 0.6 0.4 0.2 D/E Ratio 0.00 0.25 0.67 1.50 0.2 Cost of Equity (rs) 12.25% 13.65% 16.03% Levered Beta (b) 1.25 - 1.79 2.47 4.50 WACC 12.25% 11.86% 0.4 0.6 0.8 7.20% 7.70% 8.90% 11.90% BBB BB C 11.79% - 35.00%

Aug 17 2020 View more View Less

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