Question 2 [40 points]

The Perpetual Motion Machine (PMM ) makes childrenis toys and it has survived the pandemic. The new CEO of PMM, Ms. Bickering, is considering a change in capital structure and you have been asked to help her out in estimating the eect on PMM is value, cost of capital, etc.

PMM currently maintains a constant debt to value ratio of 25% for a rating of AAA. Ms. Bickering wants to maintain a debt to value ratio of 50%. You estimate this will lower its rating to A but still keep the possibility of Onancial distress remote and negligible. The estimated tax rate for PMM is 20%. Its estimated free cash aows next year is $90 million expected to grow at 2%. PMM is current weighted average cost of capital is 12%. You have gathered the following market information on ratings and average credit spreads for long term corporate bonds:

Rattings AAA AA A Credit spread 100bp 150bp 200bp

You also estimate the expected market risk premium to be 7% and the yield on long term US treasuries to be 4.5%.

Fill out the matrket value, beta and return balance sheets for PMM at the current and target capital structure. Provide super-brief explanations of why a number changes (if it does) as a result of the capital structurechange(e.g.,byMM-1). Youcanroundtothenearestmillionforadollarvalueandtothesecond decimal place for a rate of return. SHOW YOUR CALCULATIONS CLEARLY (if you want points).

Assets Liab. & Eq. Assets Liab. & Eq. Current: U = D= Target: U = D=

PVTS= E= PVTS= E= V=V=V=V=

Assets Liab. & Eq. Assets Liab. & Eq. Current: U= D= Target: U= D=

TS= E= TS= E= V=V=V=V=

Current:

Assets

rU = rTS = rV =

Liab. & Eq.

rD = rE =

rV =

Target:

Assets

rU = rTS = rV =

Liab. & Eq.

rD = rE =

rV =