Question
XYZ, Inc. is considering purchasing Widget, Inc. XYZ would finance the purchase using its current target mix of debt and equity: 60% debt, 40% equity.
XYZ, Inc. is considering purchasing Widget, Inc. XYZ would finance the purchase using its current target mix of debt and equity: 60% debt, 40% equity. Widget currently has 8% coupon debt outstanding, which pays interest semiannually, matures in 25 years and is now priced at $833.13 per bond. Widget equity is not publicly traded, so its beta is not available. You can gather the following information however:
Historical risk premium 6.5%
Long run T-bonds 6.0%
In addition, you found a portfolio of comparable firms to Widget. The beta of such portfolio is 1.6, and its debt/equity ratio is 1. In addition, XYZ'a marginal tax rate is 40%. The expected internal rate of return on Widget's cash flows is 12%. Should XYZ purchase Widget?
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