Levering the Unlevered Cost of Capital A company's management is considering alternative ways of financing the company. Going forward, the company plans to adopt a target capital structure with some com- bination of short-term and long-term debt as well as preferred stock and common equity. Below, we show the three options management is considering. Chapter 10 je dois cancer teverge of tee Color Debt to firm value. Preferred stock to firm value Unlevered cost of capital, Debt cost of capital Preferred stock cost of capital Equity cost of capital Income tax rate for all income Option 1 10.0% 40.0% 10.0% 6.096 9.0% ??? 40.0% Option 2 Option 3 10.0% 70.0% 10.0% 10.0% 10.0% 10.0% 6.0% 7.0% 8.0% 8.0% ??? ??? 40.0% 40.0% a. For each option, calculate the equity cost of capital and weighted average cost of capital under the assumption that interest is tax deductible and that (i) the discount rate for interest tax shields is the unle- vered cost of capital. (ii) the discount rate for interest tax shields is the debt cost of capital (zero-growth with fixed amount of perpetual debt), and (iii) the company refinances itself annually to a target capital structure (use the debt cost of capital for the first year and the unlevered cost of capital for subsequent years). For each option and cach alternative assumption about valuing the tax shields: i. Value the firm and the equity using the WACC DCF method. ii. Value the fim using the APV DCF method. iii. Value the equity using the Equity DCF method. iv. Explain any discrepancies between the valuations b. Levering the Unlevered Cost of Capital A company's management is considering alternative ways of financing the company. Going forward, the company plans to adopt a target capital structure with some com- bination of short-term and long-term debt as well as preferred stock and common equity. Below, we show the three options management is considering. Chapter 10 je dois cancer teverge of tee Color Debt to firm value. Preferred stock to firm value Unlevered cost of capital, Debt cost of capital Preferred stock cost of capital Equity cost of capital Income tax rate for all income Option 1 10.0% 40.0% 10.0% 6.096 9.0% ??? 40.0% Option 2 Option 3 10.0% 70.0% 10.0% 10.0% 10.0% 10.0% 6.0% 7.0% 8.0% 8.0% ??? ??? 40.0% 40.0% a. For each option, calculate the equity cost of capital and weighted average cost of capital under the assumption that interest is tax deductible and that (i) the discount rate for interest tax shields is the unle- vered cost of capital. (ii) the discount rate for interest tax shields is the debt cost of capital (zero-growth with fixed amount of perpetual debt), and (iii) the company refinances itself annually to a target capital structure (use the debt cost of capital for the first year and the unlevered cost of capital for subsequent years). For each option and cach alternative assumption about valuing the tax shields: i. Value the firm and the equity using the WACC DCF method. ii. Value the fim using the APV DCF method. iii. Value the equity using the Equity DCF method. iv. Explain any discrepancies between the valuations b
