Deben Plc currently has 100m of debt and 400m of equity. The company's management believes that they could take advantage by issuing more debt in two-year time if the interest rate still stays in this historically low level. Their target capital structure consists of 40% of debt and 60% of equity. As a financial analyst, the management ask you to answer a number of questions before they make their decisions. Assume that you have collected the following information: The risk free rate on government bonds is 2% and the expected return on the market is 5%. You may assume that the cost of equity and the cost of debt are given by the CAPM. The current levered equity beta is 1.5 and debt beta is 0.1. The corporation tax rate is 20%. The projected free cash flows for the first, second and third years are 10m, 12m and 14m respectively. After the third year, the free cash flows are expected to increase in perpetuity at 3% and they are not affected by the capital structure. All free cash flow will be used to pay interest expenses, net of tax relief, and any remainder will be used to adjust the debt levels. Suppose at the end of year 3 the company wants to issue more debt to achieve the planned long term financing mix of 60% equity and 40% debt. The increase in leverage will increase the debt beta to 0.2.

REQUIRED: (a) Estimate the weighted average cost of capital and use it to estimate the value of firm at the end of current year, year 1, year 2 and year 3 if the company keeps the current capital structure.

(b) Suppose the management will apply the Ruback active debt management policy. Estimate the unlevered cost of equity.

(c) At the end of year 3, if the capital structure is going to change as planned, estimate the long term levered cost of equity and weighted average cost of capital.

(d) Calculate the value of the firm at the end of year 3 using both a weighted average cost of capital and the adjusted present value (APV) framework. Explain how much new debt has been raised at the end of year 3.

(e) Explain why or why not you expect the difference between your answers in (a) and (d) before and after year 3.