Triad Labs has total assets of $120 million and $40 million of debt in its capital structure. Its current cost of equity is 13%, and its cost of debt is 8.5%. Triad is considering increasing its debt to $70 million and purchasing its own stock with proceeds from the sale of $30 million in debt with a cost of 9.5%, reducing equity to $50 million. The cost of equity will increase to 14.5%. Net operating income (EBIT) will remain at $12 million. If Triad has a marginal tax rate of 40%, should the firm increase its debt? Assume that both debt and EBIT are perpetual.
A) No, the value of the firm decreases $15.9 million
B) No, the value of the firm decreases $30.0 million
C) Yes, the value of the firm increases $14.1 million
D) Yes, the value of the firm increases $30.0 million

Question

Quizplus · Accepted Answer

The value of the firm increases due to the tax shield from the additional debt. The increase in firm value is calculated using the formula for the value of a leveraged firm: V_L = V_U + (Tax Rate * Debt). The increase in debt provides a tax shield that increases the firm's value by $14.1 million.

Triad Labs Has Total Assets of $120 Million and $40