Company ABC is currently unlevered. It uses the CAPM to estimate its cost of common equity,...

  

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Company ABC is currently unlevered. It uses the CAPM to estimate its cost of common equity, and at the time of the analysis the risk-free-rate is 5%, the market risk premium is 6%, and the company's tax rate is 31%. It estimates that its beta now (which is "unlevered" because it currently has no debt) is 0.87. Further, over the next two years, the company's capital budgeting needs and NI are as follows: Year Capital Budgeting Needs Net Income 1 $15 million $10 million 2 $12 million $10 million a. What is firm's current WACC? b. How much can be paid out as dividends in each year according to the residual model theory? Will the company have to raise external equity to fund its capital budgeting needs and if so, how much will it have to raise combined across the 2 years? c. The company is maturing and would like to add some debt to take advantage of low interest rates and the tax shield. It decides that its target debt (to value) ratio will be kept flexible between 25% and 40% (i.e., manager can choose to keep it at any level in this range). What is the range of its WACC if the pre-tax cost of debt will be 7% at 25% debt (to value) and 8% at 40% debt (standard assumption that any capital debt raised during re- financing will be used to repurchase shares applies? d. If the firm goes through with its proposed re-financing in part b and determines it dividends using the residual model: i. What is the maximum dividends it can pay each year? ii. What is the amount it must raise through debt financing each year if it seeks to pay $1 dividend per share in each of the two years? Is the debt amount raised compatible with its target debt ratio? iii. Which of the two above options would you propose the firm use for its dividend policy? Explain. Company ABC is currently unlevered. It uses the CAPM to estimate its cost of common equity, and at the time of the analysis the risk-free-rate is 5%, the market risk premium is 6%, and the company's tax rate is 31%. It estimates that its beta now (which is "unlevered" because it currently has no debt) is 0.87. Further, over the next two years, the company's capital budgeting needs and NI are as follows: Year Capital Budgeting Needs Net Income 1 $15 million $10 million 2 $12 million $10 million a. What is firm's current WACC? b. How much can be paid out as dividends in each year according to the residual model theory? Will the company have to raise external equity to fund its capital budgeting needs and if so, how much will it have to raise combined across the 2 years? c. The company is maturing and would like to add some debt to take advantage of low interest rates and the tax shield. It decides that its target debt (to value) ratio will be kept flexible between 25% and 40% (i.e., manager can choose to keep it at any level in this range). What is the range of its WACC if the pre-tax cost of debt will be 7% at 25% debt (to value) and 8% at 40% debt (standard assumption that any capital debt raised during re- financing will be used to repurchase shares applies? d. If the firm goes through with its proposed re-financing in part b and determines it dividends using the residual model: i. What is the maximum dividends it can pay each year? ii. What is the amount it must raise through debt financing each year if it seeks to pay $1 dividend per share in each of the two years? Is the debt amount raised compatible with its target debt ratio? iii. Which of the two above options would you propose the firm use for its dividend policy? Explain.

Answer rating: 100% (QA)

A Since the company is unlevered ie there is no debt we will calculate the WACC by using CAPM model ... View the full answer