Capital Structure Decision with Financial Distress Costs
Ravensmoor Industries has 40 million in debt (book and market value) at an 8% coupon and 60 million in equity at market value. EBIT is expected to be 12 million in perpetuity, and the corporate tax rate is 25%. The CFO proposes issuing an additional 30 million in debt to repurchase equity, arguing that 'debt is cheaper than equity, so more debt always lowers WACC.' The new debt would carry a 9.5% coupon because rating agencies have signaled a downgrade. Analysts estimate that the probability of financial distress rises from 2% to 12% with the additional leverage, and that distress would destroy 25% of unlevered firm value through direct and indirect costs. The company has a covenant limiting total debt to 3.0× EBITDA; current EBITDA is 20 million.
1. Test the CFO's claim that adding debt always lowers WACC, using the trade-off theory and the given numbers.
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The CFO's claim is wrong because it ignores the offsetting effects of financial distress and the rising cost of debt. Under trade-off theory, firm value = unlevered value + PV(tax shield) − PV(financial distress costs). WACC falls with leverage only up to the point where the tax shield benefit is outweighed by distress costs.
Current position. Unlevered value: EBIT(1−t)/r0. With current debt, estimate the tax shield: 40 × 25% = 10 million (perpetuity approximation at the debt level). Current distress cost: 2% × 25% × unlevered value. Unlevered value ≈ [EBIT(1−t)]/r0; using the current WACC as a proxy, equity value 60 + debt 40 = 100 million enterprise value. So distress cost ≈ 0.02 × 0.25 × 100 = 0.5 million. Net value ≈ 100.
Proposed position. New debt 70 million, tax shield = 70 × 25% = 17.5 million, an incremental shield of 7.5 million. But distress cost rises to 12% × 25% × unlevered value ≈ 0.12 × 0.25 × 100 = 3.0 million, an incremental 2.5 million. Net incremental benefit ≈ 7.5 − 2.5 = 5.0 million, so the proposal appears value-adding on these estimates-but the debt cost rises from 8% to 9.5%, and the covenant must be checked. The key point: the benefit is not automatic; it depends on the marginal tax shield exceeding the marginal distress cost. The CFO's blanket statement is incorrect even if this particular deal passes.
2. Check the debt covenant and assess how the downgrade risk affects the recommendation.
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Covenant test. Total debt after issuance = 40 + 30 = 70 million. EBITDA = 20 million. 3.0× EBITDA = 60 million. 70 > 60, so the proposal breaches the covenant and cannot proceed as structured. To stay within 3.0×, maximum total debt = 60 million, so additional debt capacity is only 20 million, not 30 million. Alternatively, EBITDA would need to rise to 70/3.0 = 23.33 million, a 16.7% increase, which is not supported by current projections.
Downgrade and cost of debt. The 9.5% coupon reflects higher default risk. If the rating falls further, the cost of debt rises and the tax shield is partly offset by higher expected distress costs. Also, the interest coverage ratio falls: EBIT 12 / interest (70 × 9.5% = 6.65) = 1.8×, versus current 12 / (40 × 8% = 3.2) = 3.75×. A coverage ratio near 1.8× may trigger additional covenants and reduce financial flexibility.
Recommendation. Do not issue 30 million. The covenant caps additional debt at 20 million. Even at 20 million, re-run the trade-off: incremental tax shield = 20 × 25% = 5 million; incremental distress cost depends on the new probability (between 2% and 12%). Recommend a staged approach-issue up to 20 million, monitor the rating, and revisit if EBITDA grows. The CFO's 'debt is cheaper' heuristic ignores covenant constraints, rising marginal borrowing costs, and distress costs.