Company Three, Inc. is considering entering in to a new business and therefore needs to estimate the WACC for projects associated with the new venture. Their lead analyst has compiled the following list of comparable firms in the new industry. You note that all of the firms have different capital structures and that should be taken into account. Assume that the current Treasury bill rate is 1.0% and the market risk premium is 7%.

(a) Assuming Three, Inc. will be subject to a marginal tax rate of 35% in the new venture, find an appropriate WACC that you should use for this new venture if it is funded with 100% equity. Assume the debt of each of the comparable companies is risk-free. [7 points]

(b) Now, assuming that Three, Inc. will be subject to a marginal tax rate of 35% in the new venture, find an appropriate WACC that you should use for this new venture if it is financed with 50% debt and 50% equity. Assume the debt is risk-free. [7 points]

(c) Finally, assuming there is a negligible risk of bankruptcy with 50% debt, would you recommend using debt financing for the new venture or all equity?

Table 2: TWO, Inc. Company Equity Beta Market Value of Debt Market Value of Equity A 1.2 100 50 B 1.4 100 45 0.8 100 90 D 0.4 100 200