Casino Royal, a large leisure-time company owning three casinos in Las Vegas, had debt outstanding of $1.180 billion in 1993, and 45.99 million shares outstanding, trading at $9 per share. The debt is rated B- and commands a pre-tax interest rate of 10.31%. The company had $236 million in earnings before interest and taxes in 1993, and depreciation of $109 million. (Capital expenditures amounted to $125 million in 1993.) The stock had a beta of 2.20.

Casino Royal's is planning to pay down debt and reduce its debt ratio (D/(D+E)) to 50%, which should raise its debt rating to A (and lower the pre-tax rate to 7.51%). The tax rate for the firm is 40%. The treasury bond rate is 7%. The equity risk premium is 6%.

A.What is Casino Royal's current cost of capital?

B.What will the effect of the debt reduction be on the cost of capital?

C.The firm value is expected to increase by $100 million as a consequence of the debt reduction. Assuming that the firm is in steady state, what is the expected growth rate in cash flows to the firm that will yield this value increase?