1. Estimation of WACC (35 points):

There are several ways that one can value a company, and the most popular ones are WACC (weighted average cost of capital) and APV (adjusted present value). In this section, you will be estimating Walt Disney Companys WACC using its actual financial data. Complete the following tasks and present your answers in an easy to read format with all calculations rounded to 4 decimal places. You can obtain the data from any source that you like. The following links are for suggestion purpose only.

a. Obtain the risk-free rate. Go to http://finance.yahoo.com/bonds/composite_bond_rates and find the yield to maturity for ten-year Treasury bonds. Use this number as your risk-free rate.

b. Obtain market value of equity and equity beta. Go to http://www.nasdaq.com/ and search Walt Disneys ticker symbol (DIS). Collect Disneys market value and equity beta. (Market value is computed using last sale price multiplied by number of shares outstanding you can verify that yourself.)

c. Obtain cost of debt and market value of long-term debt. To get Disneys cost of debt and the market value of its long-term debt, you will need the price and yield to maturity of the firms existing long-term bonds. Go to http://finra-markets.morningstar.com/BondCenter/ Under Search, click Corporate and type Disneys ticker symbol. A Disneys outstanding bond issue will appear. Collect the bond price and size of the issue. Note that this amount is quoted in thousands of dollars, e.g. $300,000 means $300 million. The price the bond issued is reported as a percentage of the bonds par value. For example, 108.65 means the bond issue is trading at 108.65% of its par value. You can calculate the market value for each bond issue by multiplying the amount outstanding by price/100. This is the market value of Disneys debt.

e. Calculate the weights. Calculate the weights for Disneys equity and debt based on the market value of equity and debt.

f. Calculate the cost of equity. Use the risk-free rate and equity beta collected earlier and a market risk premium of 7.6%, calculate Disneys cost of equity using the CAPM.

g. Calculate Disneys WACC. Assume that Disney has a corporate tax rate of 35%. Calculate DisneysWACC using the following equation

h. Suppose Disney were an unlevered firm (i.e. financed only with equity), what would its equity beta be? How risky are Disneys assets? Hint: A firms equity risk is a combination of business risk and financial risk. Use the CAPM and the cost of debt to get debt beta.

2. Capital Structure and Firm Value (45 point)

Capital structure decisions determine how firms are financed in the long-run. Depending on the circumstances, a firms capital structure decision may increase its total value. In this section, you will be analyzing Activision Blizzard Incs capital structure decision. Suppose you are working for Activision, currently an all-equity firm, and have been asked by your boss to analyze a potential debt issuance to repurchase shares. Complete the following tasks and present your answers in an easy to read format with all calculations rounded to 4 decimal places. There are two parts in this section.

Part I (20 points)

For the first part, assume Activision pays no taxes. If you are troubled by why companies may pay no taxes, you can imagine that Activision has been granted a special exemption such that all of its income is not taxable. This is actually not at all that uncommon - General Electric paid no federal corporate income tax at all despite making a pro t of $5.1 billion from its US operations in 2010.

Calculate WACC. Following the same steps as section 1, calculate Activisions WACC using a market risk premium of 7.6% and the risk-free rate that you obtained. Activision Blizzard Incs ticker symbol on NASDAQ is ATVI. For this section, collect also the current stock price and number of shares outstanding. Hint: Activision is currently an all-equity firm, so there is no debt outstanding.

Obtain cost of debt. Activision announces its intention to issue debt to repurchase equity. In particular, it will issue $2 billion of 10-year bonds at par to repurchase shares at market price.

Assume Activisions bonds will be rated at A by rating agencies. Go to http://finance.yahoo.com/bonds/composite_bond_rates?bypass=true and find the yield to maturity for ten-year A-rated corporate bond.

Activision plans to keep the bonds in perpetuity, i.e. it plans to roll over and reissue the bonds again at the same amount when the current bonds come due. Determine new market value of equity after the announcement. Activision will buy back shares at the market price after announcement. What is the stock price after the announcement? How many shares will Activision buy back, and how many shares will Activision have after the buy back? What is the market value of equity after the buy back? What is the stock price after the shares are repurchased?

What is the market value D/E ratio? Calculate Activisions required return on equity using

Calculate Activisions new WACC after debt issuance and share repurchase.

Explain the relationship between capital structure and WACC in this part.

Part II (25 points)

For this part, assume Activision is subject to corporate tax rate of 35%. Go all the way back to step 1 of last part. We will redo the calculations of the first part, but now in the presence of taxes.

Activision will issue $2 billion of 10-year bonds at par to repurchase shares at market price. Assume again that Activision plans to keep the bonds in perpetuity and they will be rated at A by rating agencies. Determine the present value of tax shield.

Determine new market value of equity after the announcement. Activision will buy back shares at the market price after announcement. What is the stock price after the announcement? How many shares will Activision buy back, and how many shares will Activision have after the buy back? What is the market value of equity after the buy back? What is the stock price after the shares are repurchased? Hint: Use APV to value the levered firm.

What is the market value D/E ratio? Calculate Activisions required return on equity using

Calculate Activisions new WACC after debt issuance and share repurchase. Compare this WACC to the previous one without taxes and explain why they are the same or different.

Based on the stock price, does the debt increase and share repurchase appear to be a good idea? Do you think Activisions executives should issue more debt than the $2 billion suggested in this case? What issues might the executives raise that are not considered in your analysis?

3. Costs and Benefits of Debt (40 points)

These questions are designed to develop your understanding of how leverage affects firm value. Your responses will be graded based on the quality and depth of the discussion. A good response in this section will demonstrate a clear understanding of the concepts discussed in class. A great response will be one that goes above and beyond the materials discussed in class and supports the discussion with new perhaps real-world examples. Companys business characteristics, financial figures, ratios and news articles are good examples of what you may want to consider. Cite your sources clearly.

Brevity is a virtue, so please limit your response in this section to no more than 600 words.

Briefly explain what the Trade-Off Theory is. What is its implication for capital structure? How do you explain why different firms may choose different capital structure? Illustrate your point conceptually using both the APV and WACC method. (5 points)

While debt can be beneficial for firms that can utilize the interest tax shield, it can also come at a cost. Explain what risk-shifting is and give an example. How does it differ from debt overhang? Why and how might these problems be costly for investors of the firm? What kinds of companies are more likely to be prone to these problems? Be as specific as you can when describing those companies. Suggest ways to alleviate these problems. (15 points)

c. You are having a coffee chat in downtown Evanston with a friend who has just started working as a stock analyst and are talking about leverage and firm value. While working, your friend noticed that Apple (AAPL), Peets Coffee (PEET), and Urban Outfitter (URBN) are all unlevered even though they have enough profits to bene t from the interest tax shield. They are also very cash-rich; Apple, for example, has over $9.8 billion in cash on its balance sheet as of September 2011. She concludes that all these firms are clearly not maximizing shareholder value, because they are leaving money on the table. Do you agree with her statement? Explain your answer completely. Hint: There is no definite answer for this question, so think of it as an open debate. Support your argument with facts and evidence. A simple repetition of the answers to the first two questions will not earn you any credit. (20 points)