Reference no: EM132752265

(a) Firm A's capital structure contains 30 percent debt and 70 percent equity. Firm B's capital structure contains 50 percent debt and 50 percent equity. Both firms pay 6 percent annual interest on their debt. The stock of Firm A has a beta of 1.0, and the stock of Firm B has a beta of 1.375. The risk-free rate of interest equals 4 percent, and the expected return on the market portfolio equals 12 percent.

Required:

(i) Calculate the WACC for each firm, assuming there are no taxes.

(ii) Recalculate the WACC figures, assuming that the firms face a marginal tax rate of 34 percent. (iii) Explain how taking taxes into account in part (ii) changes your answer from part (i).

(b) Winston Industries has a debt-equity ratio of 2. Its WACC is 10%, and its cost of debt is 12%. The corporate tax rate is 35%.

Required:

(i) What is Winston's cost of equity capital?

(ii) What is Winston's unlevered cost of equity capital?

(iii) What would the cost of equity be if the debt-equity ratio were 2?

(c) Robin Ltd plans to set up a brokerage business. The brokerage business will provide a net cash inflow of €80,000 for the firm during the first year, and the cash flows are projected to grow at a rate of 6 per cent per year for ever. The project requires an initial investment of €800,000.

Required:

(i) If Robinhood Ltd requires a 12% return on such undertakings, should the brokerage business be started?

(ii) The company is somewhat unsure about the assumption of a 6% growth rate in its cash flows. At what constant growth rate would the company just break even if it still required a 12% return on investment?