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Here is Establishment Industries� market-value balance sheet (figures in millions):

 

Net working capital $ 700 Debt $ 1080
Long-term assets 2600 Equity 2220
Value of firm $ 3300 $ 3300

 

The debt is yielding 0.64%, and the cost of equity is 14.6%. The tax rate is 32%. Investors expect this level of debt to be permanent.

 

a. What is Establishment�s WACC? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

 

b. How would the market-value balance sheet change if Establishment retired all its debt. (Leave no cells blank – be certain to enter “0” wherever required.)

 

New Market-Value Balance Sheet
(figures in millions)
Net working capital $
0

Answer:

 
New Market-Value Balance Sheet(figures in millions)

Net working capital
700
Debt
0

0Long-term assets
2254.4
Equity
2945.4

Value of firm
2954.4
Total
2945.4

 

 

 

Working notes for the above answer is as under

a.

WACC

=wDebt×rDebt×(1 –Tc) +wEquity×rEquity

= ($1,080 / $3,300)×.064×(1 – .32) + ($2,220 / $3,300)×.146

= .1121,

or 11.21%

 

b.

If the firm retired all of its debt, its market value would decrease by the present value of the tax shield on the retired debt.

Reduction in firm value

= .32×$1,080

= $345.6

Total debt and equity

= $3,300 – 345.6

= $2954.4

If debt is zero, then equity

= $2954.4

 

The reduction in the firm’s value will also affect the value of its long-term assets, so:Long-term assets

= $2,600 – 345.6

= $2,254.4

Net working capital will remain unchanged at $700

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