David Lyons, the CEO of Lyons Bio Technologies, is concerned about his firm's level of debt financing. The company uses short-term debt to finance its temporary working capital needs, but it does not use any permanent (long-term) debt. Other technology companies average about 30 percent debt, and Mr. Lyons wonders why the difference occurs, and what its effects are on stock prices. To gain some insights into the matter, he poses the following questions to you, his recently hired assistant. a. Lyons has EBIT = $500,000 and its cost of equity is R(Reu) = 14%. Currently Lyons uses no debt
financing, but it has been told by an investment bank that it could borrow $500,000, $1,000,000, $1,500,000, or $2,000,000 at a cost of R(Rd) = 8%. There are no taxes. Assume that the MM without taxes assumptions hold.
- Complete the table below.
- Graph the relationships between R(Rd), R(Re), and CCC and leverage as measured by D/V.
D (000s)
V E D/V E/V R(Rd) R(Re) CCC
$0
$500
$1,000
$1,500
$2,000
b. Using the data given in part a., assume that Lyons is subject to a 40 percent corporate tax rate.
Repeat the part a. analysis under the MM with-tax model.
D V E D/V E/V R(Rd) R(Rd)*(1-T) R(Re) CCC
$0
$500
$1,000
$1,500
$2,000