Problem #2 (18 marks) Westbrook Water Co. is an all equity company with EBIT of $2,000,000 per year which will continue forever as the company pays out all earnings in the form of dividends (i.e. no growth). You must determine the optimal capital structure for this company. You have been provided with the following additional information: T-bills are currently yielding 1.5%; the expected return on the market is 8.5%; the companys tax rate is 40%; and costs of financial distress apply. Assume the market value of debt is equal to its book value. Value of Debt Cost of Debt (Rd) Beta PV of Financial Distress Costs $0 - 1.25 - $2,500,000 4% 1.45 ? $4,000,000 5% ? $740,000 a) What is the value and WACC of this all-equity firm? (3 marks) b) What would be the value of the company if it issues $2.5 million in debt? (4 marks) c) What would the PV of financial distress costs be if the firm issues $2.5million in debt? (2 marks) d) What would be the value of the company if it issues $4 million in debt? (2 marks) e) What would be the companys Beta if it issues $4 million in debt? (5 marks) f) What is the optimal capital structure: 0, $2,500,000, or $4,000,000? (2 marks) Problem 3 (4 marks) The Mei Corporation expects next years net income to be $15 million. The firms debt to equity ratio is currently .67. Mei has $12 million of profitable investment opportunities, and it wishes to maintain its existing debt to equity ratio. According to the residual distribution model (assuming all payments are in the form of dividends), how large should Meis dividend payout ratio be next year? Problem 4 (7 marks) The Strasburg Companys stock currently trades at $90 per share. Below is their partial balance sheet: Common Stock (1,500,000 shares outstanding) 30,000,000 Retained Earnings 15,000,000 Total 45,000,000 a) The company is considering a 3 for 2 stock split. What will be the companys stock price following the stock split? How many shares will be outstanding? Show any changes to the Balance sheet. b) If instead, the company does a 7% stock dividend. What will be the companys stock price following the stock dividend? How many shares will be outstanding? Show any changes to the Balance sheet.