1.Explain whether each of the following projects is likely to have risk similar to the average risk of the firm.

a. The Clorox Company considers launching a new version of Armor All designed to clean and protect notebook computers.

b. Google, Inc., plans to purchase real estate to expand its headquarters.

c. Target Corporation decides to expand the number of stores it has in the southeastern United States.

d. GE decides to open a new Universal Studios theme park in China.

2.Suppose Caterpillar, Inc., has 665 million shares outstanding with a share price of $74.77, and $25 billion in debt. If in three years, Caterpillar has 700 million shares outstanding trading for $83 per share, how much debt will Caterpillar have if it maintains a constant debt-equity ratio?

3.In 2006, Intel Corporation had a market capitalization of $112 billion, debt of $2.2 billion, cash of $9.1 billion, and EBIT of more than $11 billion. If Intel were to increase its debt by $1 billion and use the cash for a share repurchase, which market imperfections would be most relevant for understanding the consequence for Intel’s value? Why?

4.Suppose Goodyear Tire and Rubber Company is considering divesting one of its manufacturing plants. The plant is expected to generate free cash flows of $1.5 million per year, growing at a rate of 2.5% per year. Goodyear has an equity cost of capital of 8.5%, a debt cost of capital of 7%, a marginal corporate tax rate of 35%, and a debt-equity ratio of 2.6. If the plant has average risk and Goodyear plans to maintain a constant debt-equity ratio, what after-tax amount must it receive for the plant for the divestiture to be profitable?

5.Suppose Lucent Technologies has an equity cost of capital of 10%, market capitalization of $10.8 billion, and an enterprise value of $14.4 billion. Suppose Lucent’s debt cost of capital is 6.1% and its marginal tax rate is 35%.

a. What is Lucent’s WACC?

b. If Lucent maintains a constant debt-equity ratio, what is the value of a project with average risk and the following expected free cash flows?

c. If Lucent maintains its debt-equity ratio, what is the debt capacity of the project in part (b)?

6.Acort Industries has 10 million shares outstanding and a current share price of $40 per share. It also has long-term debt outstanding. This debt is risk free, is four years away from maturity, has annual coupons with a coupon rate of 10%, and has a $100 million face value. The first of the remaining coupon payments will be due in exactly one year. The riskless interest rates for all maturities are constant at 6%. Acort has EBIT of $106 million, which is expected to remain constant each year. New capital expenditures are expected to equal depreciation and equal $13 million per year, while no changes to net working capital are expected in the future. The corporate tax rate is 40%, and Acort is expected to keep its debt-equity ratio constant in the future (by either issuing additional new debt or buying back some debt as time goes on).

a. Based on this information, estimate Acort’s WACC.

b. What is Acort’s equity cost of capital?

7.Suppose Goodyear Tire and Rubber Company has an equity cost of capital of 8.5%, a debt cost of capital of 7%, a marginal corporate tax rate of 35%, and a debt-equity ratio of 2.6. Suppose Goodyear maintains a constant debt-equity ratio.

a. What is Goodyear’s WACC?

b. What is Goodyear’s unlevered cost of capital?

c. Explain, intuitively, why Goodyear’s unlevered cost of capital is less than its equity cost of capital and higher than its WACC.

8.You are a consultant who was hired to evaluate a new product line for Markum Enterprises. The upfront investment required to launch the product line is $10 million. The product will generate free cash flow of $750,000 the first year, and this free cash flow is expected to grow at a rate of 4% per year. Markum has an equity cost of capital of 11.3%, a debt cost of capital of 5%, and a tax rate of 35%. Markum maintains a debt-equity ratio of 0.40.

a. What is the NPV of the new product line (including any tax shields from leverage)?

b. How much debt will Markum initially take on as a result of launching this product line?

c. How much of the product line’s value is attributable to the present value of interest tax shields?

9.Consider Lucent’s project in Problem 5.

a. What is Lucent’s unlevered cost of capital?

b. What is the unlevered value of the project?

c. What are the interest tax shields from the project? What is their present value?

d. Show that the APV of Lucent’s project matches the value computed using the WACC method.

10.Consider Lucent’s project in Problem 5.

a. What is the free cash flow to equity for this project?

b. What is its NPV computed using the FTE method? How does it compare with the NPV based on the WACC method?