Reference no: EM133520896

Question 1. Your task is to estimate the WACC of McDuck's, a privately held fast-food chain in the greater Rochester area. To do so, you have collected the following information about McDuck's itself, as well as the publicly traded company McGoose's, which has the same business risk as McDuck's. McDuck's McGoose's Pre-tax cost of debt 4.5% 4% Marginal tax rate 20% 25% Capital structure 40% debt, 60% equity 20% debt, 80% equity Market beta Unknown 1.2 Finally, you know that the risk-free rate is 2% and the market risk premium is 5%.

(a) What is McGoose's cost of equity?

(b) Suppose that McGoose's is a mature company with dividends growing at a constant rate. The most recent dividend it paid was $5 per share. The current share price in the market is $90. Based on your result in part (a), what is your estimate of the dividend growth rate? (c) (15 points) What is your estimate of McDuck's cost of capital?

Question 2. Company ASDF has 10 million of common shares outstanding, traded at $70 per share. Market beta of those shares is 0.8. Expected market return is 6% and risk-free rate is 1%. The company also has 1 million of preferred stocks outstanding. Each stock is traded at $105 and pays an annual dividend of $8. It also has two bond issues outstanding. Bond A matures in 10 years, has face value of $1,000 and coupon rate of 10% (coupons are paid annually). Current market price of bond A is $1,200. Bond B is a zero-coupon bond, with face value of $1,000. It matures in 5 years and is currently traded at 80% of par. There are 100,000 bonds of A and 20,000 bonds of type B issued. Tax rate is 15%.

(a) What is the capital structure of the company (that is, what are weights of equity and debt in the company's total value)?

(b) What is the company's cost of capital?

(c) Suppose that ASDF plans to expand its operations by launching a 5-year project that has a risk profile common to existing ASDF's projects. It is also not going to change ASDF's capital structure. This project requires an initial capital investment of $2,000,000. Every year of its operation, the project is going to generate EBIT of $300,000. Fixed assets are going to be depreciated to zero using a straight line rule; their market value at the end of year 5 is zero. There will be no adjustments in net working capital. Should ASDF take this project?

Question 3. ZXC Inc. earns $250,000 EBIT on average per year and forever. It always distributes all its net earnings as dividends to its shareholders. Net working capital is always kept at zero, and there are no capital spendings. ZXC's current capital structure is 90% equity and 10% debt. There are 100,000 common shares outstanding. ZXC's current cost of equity is 16% and its cost of debt is 10%. The corporate tax rate is 40%. The CEO of ZXC Inc. considers issuing additional debt and use the proceeds to buy back shares. To be specific, the CEO is thinking about offering $0.5 million perpetual debt paying 10% coupon rate and using the money to buy back some of the shares. Ignore any bankruptcy considerations.

(a) What is the market value of ZXC Inc. if it keeps its current capital structure? What is the share price?

(b) What is the market value of ZXC Inc. after it issues $0.5 million perpetual debt paying 10% coupon per year and uses the proceeds for share buyback?

(c) What is the cost of equity and WACC of ZXC Inc. after it issues the debt?

(d) How many shares will ZXC Inc. be able to buy back? What is the new share price? Hint: Write down two equations. The first one should show that funds from the debt issuance are used to buy back shares. The second one should show that the remaining value of shares equal to the new equity value.