Question 4: (20 points) Mercer Inc. has a debt-to-equity ratio of 0.40. The required return on the companys unlevered equity is 12%, and the pretax cost of the firms debt is 8%. Sales revenue for the company is expected to remain stable indefinitely at last years level of $18,000,000+($100,000xA) (with A:1) . Variable costs (including SG & A expenses) are 65 percent of sales. The corporate tax rate is 26%+(1%xA) (with A defined above). The company distributes all its earnings as dividends at the end of each year.

a. If the company were financed entirely by equity, how much would it be worth?

b. What is the required return on the companys levered equity?

c. Use the weighted average cost of capital (WACC) approach to calculate the value of the company. What is the value of the companys equity? What is the value of the companys debt?

d. Use the flow to equity (FTE) approach to calculate the value of the companys equity (Hint: use the value of debt calculated in part c to calculate interest expense).

Question 5: (20 points)

A. Discuss the static trade-off theory and the pecking order theory of capital structure. What are the main differences between these two theories? (10 points)

B. Global Production (GP) is a large conglomerate thinking of entering the smart alarm business, where it plans to finance a project with a debt-to-value ratio of 20 percent. GP expects to borrow for its smart alarm venture at an interest rate of 10%. There is currently one firm in the smart alarm industry, American Smart Alarm (ASA). This ASA firm is financed with 25 percent debt and 75 percent equity. The beta of ASAs equity is 1+(0.1xA) (with A: the last digit of your student ID; for example, if the last digit of your student ID is 2, ASA has an equity beta of 1.2). ASA has a borrowing interest rate of 9%. The corporate tax rate for both firms is 26%+(1%xA) (with A defined above). The market risk premium is 8%, and the risk-free rate is 5%. What is the appropriate discount rate (RWACC) for GP to use for its smart alarm venture? (10 points)