Question 4: (20 points) Mercer Inc. has a debt-to-equity ratio of 0.40. The required return on the company’s unlevered e
Posted: Mon Nov 15, 2021 4:58 pm
Question 4: (20 points) Mercer Inc. has a debt-to-equity ratio
of 0.40. The required return on the company’s unlevered equity is
12%, and the pretax cost of the firm’s debt is 8%. Sales revenue
for the company is expected to remain stable indefinitely at last
year’s level of $18,000,000+($100,000xA) (with A:1) . Variable
costs (including SG & A expenses) are 65 percent of sales. The
corporate tax rate is 26%+(1%xA) (with A defined above). The
company distributes all its earnings as dividends at the end of
each year.
a. If the company were financed entirely by equity, how much
would it be worth?
b. What is the required return on the company’s levered
equity?
c. Use the weighted average cost of capital (WACC) approach to
calculate the value of the company. What is the value of the
company’s equity? What is the value of the company’s debt?
d. Use the flow to equity (FTE) approach to calculate the value
of the company’s equity (Hint: use the value of debt calculated in
part c to calculate interest expense).
Question 5: (20 points)
A. Discuss the static trade-off theory and the pecking order
theory of capital structure. What are the main differences between
these two theories? (10 points)
B. Global Production (GP) is a large conglomerate thinking of
entering the smart alarm business, where it plans to finance a
project with a debt-to-value ratio of 20 percent. GP expects to
borrow for its smart alarm venture at an interest rate of 10%.
There is currently one firm in the smart alarm industry, American
Smart Alarm (ASA). This ASA firm is financed with 25 percent debt
and 75 percent equity. The beta of ASA’s equity is 1+(0.1xA) (with
A: the last digit of your student ID; for example, if the last
digit of your student ID is 2, ASA has an equity beta of 1.2). ASA
has a borrowing interest rate of 9%. The corporate tax rate for
both firms is 26%+(1%xA) (with A defined above). The market risk
premium is 8%, and the risk-free rate is 5%. What is the
appropriate discount rate (RWACC) for GP to use for its smart alarm
venture? (10 points)
of 0.40. The required return on the company’s unlevered equity is
12%, and the pretax cost of the firm’s debt is 8%. Sales revenue
for the company is expected to remain stable indefinitely at last
year’s level of $18,000,000+($100,000xA) (with A:1) . Variable
costs (including SG & A expenses) are 65 percent of sales. The
corporate tax rate is 26%+(1%xA) (with A defined above). The
company distributes all its earnings as dividends at the end of
each year.
a. If the company were financed entirely by equity, how much
would it be worth?
b. What is the required return on the company’s levered
equity?
c. Use the weighted average cost of capital (WACC) approach to
calculate the value of the company. What is the value of the
company’s equity? What is the value of the company’s debt?
d. Use the flow to equity (FTE) approach to calculate the value
of the company’s equity (Hint: use the value of debt calculated in
part c to calculate interest expense).
Question 5: (20 points)
A. Discuss the static trade-off theory and the pecking order
theory of capital structure. What are the main differences between
these two theories? (10 points)
B. Global Production (GP) is a large conglomerate thinking of
entering the smart alarm business, where it plans to finance a
project with a debt-to-value ratio of 20 percent. GP expects to
borrow for its smart alarm venture at an interest rate of 10%.
There is currently one firm in the smart alarm industry, American
Smart Alarm (ASA). This ASA firm is financed with 25 percent debt
and 75 percent equity. The beta of ASA’s equity is 1+(0.1xA) (with
A: the last digit of your student ID; for example, if the last
digit of your student ID is 2, ASA has an equity beta of 1.2). ASA
has a borrowing interest rate of 9%. The corporate tax rate for
both firms is 26%+(1%xA) (with A defined above). The market risk
premium is 8%, and the risk-free rate is 5%. What is the
appropriate discount rate (RWACC) for GP to use for its smart alarm
venture? (10 points)