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A consultant has collected the following information regarding Hobbit Manufacturing:
Operating income (EBIT) $600 million, Interest expense $0, Tax rate
40%, Debt $0, Cost of equity 7%, WACC 7% . The company has no growth
opportunities (g = 0), so the company pays out all of its earnings as
dividends . Hobbit can borrow money at a pre-tax rate of 6%. The
consultant believes that if the company moves to a capital structure
consisting of 30% debt and 70% equity (based on market values), which
would require taking on debt in the amount of $1,617 million, that the
cost of equity will increase to 8% and the pre-tax cost of debt will
remain at 6%, but the value of the firm will rise. Is the consultant
correct? If the company makes this change, what will be the increase in
total market value for the firm?
