discussion 653



Legitron Corporation has $280 million of debt outstanding at an interest rate of 8 percent. What is the dollar value of the tax shield on that debt, just for this year, if Legitron is subject to a 36 percent Cmarginal tax rate?


Value of tax shield $____________


Marx and Spender currently has a WACC of 18 percent. If the cost of debt capital for the firm is 9 percent and the firm is currently financed with 47 percent debt, then what is the current cost of equity capital for the firm? Assume that the assumptions in Modigliani and Miller’s Proposition 1 hold. (Round answer to 2 decimal places, e.g. 17.54%.)


Current cost of equity capital ___________%


The weighted average cost of capital for a firm (assuming all three Modigliani and Miller assumptions apply) is 17 percent. What is the current cost of equity capital for the firm if its cost of debt is 8 percent and the proportion of debt to total firm value for the firm is 0.5?


Current cost of capital __________%


Backwards Resources has a WACC of 11.9 percent, and it is subject to a 34 percent marginal tax rate. Backwards has $379 million of debt outstanding at an interest rate of 10 percent and $787 million of equity (market value) outstanding. What is the expected return on the equity with this capital structure? (Round answer to 2 decimal places, e.g. 17.54%.)


Expected return on equity _____________%




Santa’s Shoes is a retailer that has just begun having financial difficulty. Santa’s suppliers are aware of the increased possibility of bankruptcy. What might Santa’s suppliers do based on this information? (essay)


A few years ago, a friend of yours started a small business that develops gaming software. The company is doing well and is valued at $1.5 million based on multiples for comparable public companies after adjustments for their lack of marketability. With 300,000 shares outstanding, each share is estimated to be worth $5. Your friend, who has been serving as CEO and CTO (chief technology officer), has decided that he lacks sufficient managerial skills to continue to build the company. He wants to sell his 160,000 shares and invest the money in an MBA education. You believe you have the appropriate managerial skills to run the company. Would you pay $5 each for these shares? What are some of the factors you should consider in making this decision? (essay)




A friend of yours is trying to value the equity of a company and, knowing that you have read this book, has asked for your help. So far she has tried to use the FCFE approach. She estimated the cash flows to equity to be as follows: (essay)










Earnings before taxes (EBT)


-Taxes (0.35 x EBT)


= Cash Flow to Equity



She also computed the cost of equity using CAPM as follows:

kE = kF + βE(Risk premium) = 0.06 + (1.25 x 0.084) = 0.165, or 16.5%

where the beta is estimated for a comparable publicly traded company. Using this cost of equity, she estimates the discount rate as

WACC = xDebtkDebtpretax(1 – t) + xcskcs

= [0.20 x 0.06 x (1-0.35)]+(0.80 x 0.165) = 0.14, or 14%

Based on this analysis, she concludes that the value of equity is $159.9 million/0.14 = $1,142 million.

    Assuming that the numbers used in this analysis are all correct, what advice would you give your friend regarding her analysis?

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