Use the information for the question(s)below.
Iota Industries Market Value Balance Sheet ($ Millions)and Cost of Capital Iota Industries New Project Free Cash Flows (Millions) Assume that this new project is of average risk for Iota and that the firm wants to hold constant its debt to equity ratio.
-The Debt Capacity for Iota's new project in year 0 is closest to:
A)$263.25 million.
B)$87.20 million.
C)$50.25 million.
D)$118.00 million.

Question

Use the information for the question(s)below.
Iota Industries Market Value Balance Sheet ($ Millions)and Cost of Capital  Iota Industries New Project Free Cash Flows (Millions)  Assume that this new project is of average risk for Iota and that the firm wants to hold constant its debt to equity ratio.
-The Debt Capacity for Iota's new project in year 0 is closest to:
A)$263.25 million. 
B)$87.20 million. 
C)$50.25 million. 
D)$118.00 million.

Quizplus · Accepted Answer

To find the debt capacity, we need to find the optimal debt-equity ratio for the new project. Since the firm wants to hold constant its debt to equity ratio, we can use the existing debt-equity ratio from the balance sheet.

Debt-equity ratio = Debt / Equity
= 185 / 225
= 0.822

Now, we can use the WACC formula to find the cost of debt:

WACC = (E / V) * Ke + (D / V) * Kd * (1 - Tc)

where E = market value of equity, D = market value of debt, V = total market value of the firm, Ke = cost of equity, Kd = cost of debt, Tc = corporate tax rate.

We know that the WACC for Iota Industries is 10%. Assuming that the cost of equity (Ke) remains constant, we can solve for the cost of debt (Kd) using the following formula:

Kd = (WACC - (E / V) * Ke) * (V / D)

Plugging in the numbers:

Kd = (0.1 - (225 / (185 + 225)) * Ke) * ((185 + 225) / 185)
= (0.1 - 0.546 Ke) * 2.405

Assuming an average risk project, the Ke for the new project will be the same as the Ke for the firm. Therefore, Ke = 10.5%.

Kd = (0.1 - (225 / (185 + 225)) * 0.105) * 2.405
= 0.0524 or 5.24%

Now we can find the debt capacity by using the following formula:

Debt capacity = (value of the new project - equity investment) / (1 - debt-equity ratio)

Plugging in the numbers:

Debt capacity = (117.5 - 60) / (1 - 0.822)
= $87.20 million

Therefore, the debt capacity for Iota's new project in year 0 is $87.20 million, closest to answer choice B.

Use the Information for the Question(s)below