This is an individual assignment. Working together is not allowed.

You can turn in your work in Word, Excel or scanned hand-written files. Please show your work neatly and clearly and include all calculations. Partial credit will be considered.

Please keep 4 decimals in your intermediate calculation, and 2 decimals in your final answer.

1. As the CFO of Finance Rocks (FR) Inc., you are considering building a book factory. You determine that you will use a D/E ratio of 2 and the after-tax cost of debt is 5%. To get the cost of equity for the factory you plan to use information from a comparable firm, Accounting Not So Much (ANSM) Inc. The beta on ANSM’s stock is 1.2 and its D/E is 1. If the T-bond rate is 6% and Market Risk Premium is 5.5%. The tax rate for FR and ANSM is 40%. Assume both firms have no bankruptcy risk and debt beta is zero. (20 points)
   1. What is the cost of equity for the project?
   2. What is the project’s WACC?
2. Pfizer is a large biotechnology company. Until now, Pfizer has been completely equity financed. Management feels that Pfizer is a maturing company with steady earnings, so they are considering adding debt to the capital structure. Specifically, Pfizer is considering issuing $10 billion in debt at 7% to finance share repurchases. Pfizer’s market capitalization is $100 billion. There is no risk of bankruptcy. The company’s marginal tax rate is 35%. (20 points)
   1. Estimate the annual tax savings from debt.
   2. Assuming the company continues to have the same amount of debt forever, what is thepresent value of this tax shield?

Number of Questions: 3 Total Points: 60 DUE: 11:59pm Apr 10, 2022

1

c. According to tradeoff theory, what should the new value of the firm be? What is the value of the firm’s equity? How much would the firm’s current shareholders benefit by the move?
(Hint: Week 10 Lecture Slides #2 – Capital Structure Theory III – Slides #16 to #19.)

3. McDonald’s Corp has hundreds of thousands of employees. Rather than paying an insurance company to insure its employees, McDonald’s is thinking about starting to insure its own employees. Obviously, the risk of the insurance industry is not the same as the risk of the fast-food industry, so McDonald’s is trying to come up with a cost of capital for the project. To accomplish this, McDonald’s is going to use the “pure plays” technique. Assume no risk of bankruptcy for McDonald’s or any of the pure play companies. Assume all companies have a marginal tax rate of 35%. The insurance division of McDonald’s would have a debt-to-equity ratio of 0.6. The cost of debt for the new division is 4.5%, which is also the risk free rate. The debt beta is zero for all companies. The market risk premium is 5.5%. Information on pure plays is listed below. Find the WACC for McDonald’s new division. (20 points)

Company AFLAC
Aon Corp Conseco Corp Unum Group

Equity Beta 0.25
1.48
1.37

1.52

D/E Ratio 0.171 0.438 0.301 0.345