Santa Fe Pacific, a major rail operator with diversified operations, had earnings before interest, taxes, and depreciation of \($637\) million in 1993, with depreciation amounting to \($235\) million (offset by capital expenditure of an equivalent amount). The firm was in steady state and expected to grow 6% a year in perpetuity. Santa Fe Pacific had a beta of 1.25 in 1993, and debt outstanding of \($1.34\) billion. The stock price was

\($18.25\) at the end of 1993, and there were 183.1 million shares outstanding. The expected ratings and the costs of debt at different levels of debt for Santa Fe are shown in the following table:

The earnings before interest and taxes were expected to grow 3% a year in perpetuity, with capital expenditures offset by depreciation. (The tax rate was 40%, and the Treasury bond rate was 7% and the market risk premium was 5.5%.)

a. Estimate the cost of capital at the current debt ratio.

b. Estimate the costs of capital at debt ratios ranging from 0% to 90%.

c. Estimate the value of the firm at debt ratios ranging from 0% to 90%.

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D/(DE) Rating Cost of Debt (Pretax) 0% AAA 6.23% 10% AAA 6.23% 20% A+ 6.93% 30% A- 7.43% 40% BB 8.43%