Question 3

Firm As capital structure contains 20% debt and 80% equity. Firm Bs capital structure contains 50% debt and 50% equity.

Both firms pay 7% annual interest on their debt. Firm As shares have a beta of 1.0 and Firm Bs beta of 1.375. The risk-free rate of interest equals 4%, and the expected return on the market portfolio equals 12%.

Required A. Calculate the WACC for each firm assuming there are no taxes.

B. Recalculate the WACC figures assuming that the two firms face a marginal tax rate of 34%. What do you conclude about the impact of taxes from your WACC calculations?

C. Explain the simplifying assumptions managers make when using WACC as a project discounting method and discuss some of the common pitfalls when using WACC in capital budgeting.

D. What are the important direct and indirect costs of bankruptcy? Which of these, do you think, are the most important in discouraging maximum debt use by corporate managers?