The objective of this case study is to understand how corporations determine their optimal financing policies. In Part I, you will focus on analyzing the decision to increase financial leverage. Note that the case has some typos and the number of shares outstanding is not consistent throughout. For this case assignment, please assume that the company has $36$ million shares before the repurchase and $26$ million shares afterwards.

$1.$ Discuss Wilson$$s statement: $$Equity in the case of Marriott costs about $17\%$ after tax; that is$,$ the investor expects to earn $17\%$ on an investment in Marriott$$s stock. Debt costs only about $5\%$ after tax. Given an investment that earns $10\%$ after tax, it is evident that the more debt that I have in my capital structure, the lower will be the cost of my capital, and the more return I will have left over for the holders of my common stock. Since debt is so cheap relative to equity, it would seem attractive to use as much debt as possible in a capital structure. In fact, if cost were the sole criteria for selection, one would use $100\%$ debt.$$

$(1)$ Where did Wilson get the number $17\%?$ Is it a proper measure of the cost of equity $()?$ Why? What is your estimate of $?$

$(2)$ Do you agree with the statement $$the more debt that I have in my capital structure, the lower will be the cost of my capital... it would seem attractive to use as much debt as possible$?$ Why or why not?

$2.$ Derive the relationship between a company$$s price$-$to$-$earnings $($P$/$E$)$ ratio and its cost of equity. For simplicity, assume the company$$s future earnings per share $($EPS$)$ follow a perpetuity and all earnings are paid out as dividends. How will Marriott$$s proposed change in capital structure affect its P$/$E ratio?

$3.$ Based on your answers in $2,$ can the tender price of $$23\mathrm{.}5$ be justified from the increase in tax shield under the higher leverage? $($Hint: In answering this question, you also need to identify how the increase in tax shield affects EPS.$)$

$4.$ Wilson deems unused debt capacity $$imprudent$$ in an inflationary environment. What does he mean? Does higher leverage necessarily make sense with higher inflation?