Flash back to June 20, 2010. Your firm, Horizon Communications, a diversified telecommunications firm, is thinking about selling its phone directories unit, Orange Book, to another firm, either Mustard Book or PLURAL. Either purchaser will maintain its current capital structure in financing the acquisition and in future operations. Orange Book has only one competitor, Mustard Book, whose sole business is phone directories. (PLURAL is a diversified firm.) In trying to value this division, Horizon is confronted with the information below. (Assume a debt beta of zero for each firm and that the beta of the tax shields will equal the beta of the unlevered firm. In other words, D = 0 & Tax shield = U.)

Mustard book Horizon PLURAL

E 1.06 0.95 0.99

D/E 0.2 0.25 0.3

Tax rate 0.3 0.3 0.3

Before-tax cost of debt (rd) 0.1 0.09 0.08

Yields on U.S. Government Securities (on April 20, 2010)

Annualized Yield to Maturity

3-Month T-Bills 0.31%

1-Year Bonds 0.65%

5-Year Bonds 2.10%

10-Year Bonds 3.45%

20-Year Bonds 4.02%

30-Year Bonds 3.80%

Avg Annual Rets (1928-2008)

Average Annual Return

T-Bills 3.8%

Intermediate Bondsa 5.4%

Long-term Bondsb 5.5%

Large Company Stocksc 11.1%

Small Company Stocksd 14.5%

aPortfolio of U.S. Government bonds with maturity near 5 years.

bPortfolio of U.S. Government bonds with maturity near 10 years.

cStandard & Poor's 500 Stock Price Index.

dA subset of small cap stocks traded on the NYSE (1928-2008)

If Orange Book is to be purchased by Mustard Book, what is the appropriate E (to use as an input into the WACC) for evaluating the value of the acquisition to Mustard Book?

If Orange Book is to be purchased by PLURAL, what is the appropriate E (to use as an input into the WACC) for evaluating the value of the acquisition to PLURAL?

Calculate a cost of equity (RE) and WACC for the Orange Book acquisition, assuming that PLURAL purchases Orange Book.

How would your answer to part (c) change if PLURAL decided to lever up dramatically, to say a D/E = 1.0, and then planned on paying down debt in chunks? Please describe in words what would happen and how your analysis would (or would not) change.