C4 A1 9&10

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9. AmRail has been granted permission to transport passengers between major U.S. cities. The new company faces competition from regional railway companies that operate between major cities in their regions. The betas of the equity of the four major competitors (A, B, C, D) are 1.14, 1.17, 1.29, and 1.43; and the debt-to-equity ratios of these four companies (in the same order: A, B, C, D) are 0.14, 0.17, 0.29, and 0.43. Although these D/E ratios vary, all debt is considered risk-free in the market place because railways are expected to dominate all long-distance public transportation. Suppose the expected market risk premium (the average difference between the market return and the risk-free rate) is 6.5% and the risk free rate is 3.5%. Assume that the tax rate is 34%, the interest payments on debt are tax deductible and the tax shield on debt is as risky as the assets of a business. AmRail has decided to remain an all-equity firm for the foreseeable future. What is the cost of capital (WACC) of the company?

10. AmRail has been granted permission to transport passengers between major U.S. cities. The new company faces competition from regional railway companies that operate between major cities in their regions. The betas of the equity of the four major competitors (A, B, C, D) are 1.14, 1.17, 1.29, and 1.43; and the debt-to-equity ratios of these four companies (in the same order: A, B, C, D) are 0.14, 0.17, 0.29, and 0.43. Although these D/E ratios vary, all debt is considered risk-free in the market place because railways are expected to dominate all long-distance public transportation. Suppose the expected market risk premium (the average difference between the market return and the risk-free rate) is 6.5% and the risk free rate is 3.5%. Assume that the tax rate is 34%, the interest on debt is tax deductible and the tax shield on debt is as risky as the assets in the railway business. After being convinced by consultants, the CEO of AmRail decides to adopt the capital structure of comparable Company C for the foreseeable future. What is the cost of capital (WACC) of the company?