The firm's bonds are all 20-year bonds with a coupon rate of 10% which are selling at 90% of face value (the yield to maturity on these bonds is 11%). The stocks are selling at a PE ratio of 9 and have a beta of 1.25. The six-month T.Bill rate is 6%.

a. What is the firm's current cost of equity?

b. What is the firm's current after-tax cost of debt?

c. What is the firm's current weighted average cost of capital?

Assume that management of Terck Inc., which is very conservative, is considering doing an equity-for-debt swap (i.e. issuing $200 more of equity to retire $200 of debt). This action is expected to lower the firm's interest rate by 1%.

d. What is the firm's new cost of equity?

e. What is the new WACC?

f. What will the value of the firm be after the swap?

11. You have been asked to analyze the capital structure of DASA Inc, an environmental waste disposal firm, and make recommendations on a future course of action. DASA Inc. has 40 million shares outstanding, selling at $20 per share, and a debt-equity ratio (in market value terms) of 0.25. The beta of the stock is 1.15, and the firm currently has a AA rating, with a corresponding market interest rate of 10%. The firm's income statement is as follows:

EBIT $150 million

Interest Exp. $ 20 million Taxable Inc. $130 million Taxes $ 52 million

Net Income $ 78 million The current T.Bill rate is 8%.

a. What is the firm's current weighted average cost of capital?

b. The firm is proposing borrowing an additional $200 million in debt and repurchasing stock. If it does so, its rating will decline to A, with a market interest rate of 11%. What will the weighted average cost of capital be if they make this move?

c. What will the new stock price be if the firm borrows $200 million and repurchases stock (assuming rational investors)?

d. Now assume that the firm has another option to raise its debt/equity ratio (instead of borrowing money and repurchasing stock). It has considerable capital expenditures planned for the next year ($150 million). The company also currently pays $1 in dividends per share. If the company finances all its capital expenditures with debt and doubles its dividend yield from the current level for the next year, what would you expect the debt/equity ratio to be at the end of the next year.

12. You have been asked by JJ Corporation, a California-based firm that manufacturers and services digital satellite television systems, to evaluate its capital structure. They currently have 70 million shares outstanding trading at $10 per share. In addition, it has 500,000 convertible bonds, with a coupon rate of 8%, trading at $ 1000 per bond. JJ Corporation is rated BBB and the interest rate on BBB straight bonds is currently 10%. The beta for the company is 1.2, and the current risk-free rate is 6%. The tax rate is 40%.

a. What is the firm's current debt/equity ratio?

b. What is the firm's current weighted average cost of capital?

JJ Corporation is proposing to borrow $250 million and use it for the following purposes:

Buy back $100 million worth of stock Pay $100 million in dividends

Invest $ 50 million in a project with a NPV of $25 million. The effect of this additional borrowing will be a drop in the bond rating to B, which currently carries an interest rate of 11%.

c. What will the firm's cost of equity be after this additional borrowing?

d. What will the firm's weighted average cost of capital be after this additional borrowing?

e. What will the value of the firm be after this additional borrowing?

13. Baldor Electric, a company which gets 85% of its revenues from industrial electric motors, had 27.5 million shares at $ 25 per share, and $ 25 million in debt outstanding at the end of 1995. The firm has a beta of 0.70, had earnings before interest and taxes of $63.3 million and a book value of equity of $200 million. The following table summarizes the ratings and interest rates for Baldor Electric at different levels of debt.

Debt Ratio

Bond Rating

Interest Rate on Debt


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