As CEO of a major corporation, you have to make a decision on how much you can afford to borrow. You currently have 10 million shares outstanding, and the market price per share is $50. You also currently have about $200 million in debt outstanding (market value). You are rated as a BBB corporation now.
• Your stock has a beta of 1.5 and the risk-free rate is 8%.
• Your marginal tax rate is 46%.
• You estimate that your rating will change to a B if you borrow $100 million. The BBB rate now is 11%. The B rate is 12.5%.
a. Given the marginal costs and benefits of borrowing the $100 million, should you go ahead with it?
b. What is your best estimate of the weighted average cost of capital with and without the $100 million in borrowing?
c. If you borrow the $100 million, what will the price per share be after the borrowing? (zero growth rate)
d. Assume that you have a project that requires an investment of $100 million. It has expected before-tax revenues of $50 million and costs of $30 million a year in perpetuity. Is this a desirable project by your criteria? Why or why not?
e. Does it make a difference in your decision if you were told that the cash flows from the project in d are certain?

  • CreatedApril 15, 2015
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