1. In the case of debt, the return paid to the debt holders is not the same as the cost to the firm.

a) How could this be? Explain.

b) Suppose a firm with a 35% tax rate borrows $100,000 at 10% interest per year. What is the firm's after-tax (or effective) cost of debt, and why is it lower than the 10% interest?

2. Consider a publishing company which is currently all equity and has a beta of 0.8. The firm has decided to move to a capital structure of one part debt to two parts equity. Assuming a zero beta for its debt, what would its equity beta become? What would the equity beta be, if the firm had one part debt to one part equity? What does this result confirm?

3. Consider a firm whose debt has a market value of $40 million and whose stock has a market value of $60 million (3 million outstanding shares of stock, each selling for $20 per share). The firm pays a 5% rate of interest on its new debt and has a beta of 1.41. The corporate tax rate is 34%. Assume that the Security Market Line holds, that the market risk premium is 9.5% and the current Treasury bill rate is 1%. What is the firm's after-tax WACC?

4. Shanken Corp. issued a 30-year, 6.2% semiannual bond 7 years ago. The bond currently sells for 108% of its face value. The company's tax rate is 35%.

a. What is the pretax cost of debt?

b. What is the after-tax cost of debt?

c. Which is more relevant, the pretax or after-tax cost of debt? Why?

5. Filer Manufacturing has 8.3 million shares of common stock outstanding. The current share price is $53, and the book value per share is $4. Filer Manufacturing has two bond issues outstanding. The first bond issue has a face value of $70 million and a coupon rate of 7%, and sells for 108.3% of par. The second issue has a face value of $60 million and a coupon rate of 7.5%, and sells for 108.9% of par. The first issue matures in 8 years, the second in 27 years.

a. What are Filer's capital structure weights on a book value basis?

b. What are Filer's capital structure weights on a market value basis?

c. Which are more relevant, the book or the market value weights? Why?

d. Suppose the company's stock has a beta of 1.2. The risk-free rate is 3.1%, and the market risk premium is 7%. Assume that the overall cost of debt is the weighted average implied by the two outstanding debt issues. Both bonds make semiannual payments. The tax rate is 35%. What is the company's WACC?

6. Assume the equity beta for Johnson and Johnson is 0.55. The yield on 10-year treasuries is 3%, and you estimate the market risk premium to be 6%. Furthermore, J&J issues dividends at an annual rate of $2.81. Its current stock price is $92, and you expect dividends to increase at a constant rate of 4% per year. Estimate J&J's cost of equity.

7. An all-equity firm is considering the following projects:

The T-bill rate is 3.5%, and the expected return on the market is 11%.

a. Which projects have a higher expected return than the firm's 11% cost of capital?

b. Which projects should be accepted?

c. Which projects would be incorrectly accepted or rejected if we used the firm's overall cost of capital?

8. Suppose Yuengling Brewery is considering introducing a new ultra-light beer with zero calories to be called YZero. The firm believes that the beer's flavor and appeal to calorie-conscious drinkers will make it a success. The cost of bringing the beer to market is $200 million, but Yuengling expects first-year incremental FCFs from YZero to be $100 million and to grow at 3% per year thereafter. If Yuengling's WACC is 5.7%, should it go ahead with the project?

9. Dupont is considering the potential acquisition of Nike. Dupont plans to offer $65 billion as the purchase price for Nike, and it will need to issue additional debt and equity to finance such a large acquisition. You estimate that the issuance costs will be $800 million and will be paid as soon as the transaction closes. You also estimate that the incremental FCFs from the acquisition will be $3.3 billion in the first year and will grow at 3% per year thereafter. What is the NPV of the proposed acquisition? Assume Nike's WACC is 7.9%.

10. Good Food Corporation, a public company, is currently a leading global food service retailer. It operates about 10,000 restaurants in 100 countries. Good Food serves a value-based menu focused on hamburgers and French fries. The company has $4 billion in market valued debt and $2 billion in market value equity. Its tax rate is 20%. Good Food has estimated its cost of debt as 5% and its cost of equity as 10%.

Good Food is seeking to grow by acquisition and has identified a potential acquisition candidate, Happy Meals. Happy Meals is currently a private firm with no publicly traded stock, but has the same product mix as Good Food and is a direct competitor to Good Food in many markets. Happy Meals has $1,318.8 million of debt outstanding, with its market value the same as the book value. It has 12.5 million shares outstanding. Since Happy Meals is a private firm, we have no stock market price to rely on for our valuation. Happy Meals expects its EBIT in year 1 to be equal to $150 million, and to grow at 10% a year for the next 5 years. Increases in NWC and capital spending are both expected to be 24% of EBIT. Depreciation will be 8% of EBIT. The perpetual growth rate in cash flow after 5 years is estimated to be 2%.

a) What is Good Food's after-tax WACC?

b) Estimate the FCFs from Happy Meals; calculate its terminal value and present value.

c) What is the maximum price (in $/share) that Good Food would be willing to pay for Happy Meals?