Problem 18-4 Suppose Goodyear Tire and Rubber Company is considering divesting one of its manufacturing plants. The plant is expected to generate free cash flows of $1.5 million per year, growing at a rate of 2.5% per year. Goodyear has an equity cost of capital of 8.5%, a debt cost of capital of 7%, a marginal corporate tax rate of 35%, and a debt-equity ratio of 2.6. If the plant has average risk and Goodyear plans to maintain a constant debt-equity ratio, what after-tax amount must it receive for the plant for the divestiture to be profitable?
We can compute the levered value of the plant using the WACC method. Goodyear’s WACC is
A divestiture would be profitable if Goodyear received more than $47.6 million after tax.
Problem 18-5 Suppose Alcatel-Lucent has an equity cost of capital of 10%, market capitalization of $10.8 billion, and an enterprise value of $14.4 billion. Suppose Alcatel-Lucent’s debt cost of capital is 6.1% and its marginal tax rate is 35%.
a.What is Alcatel-Lucent’s WACC?
b. If Alcatel-Lucent maintains a constant debt-equity ratio, what is the value of a project with average risk and the following expected free cash flows? (Using the WACC method)
Given a cost of 100 to initiate, the project’s NPV is 185.86 – 100 = 85.86.
c. If Alcatel-Lucent maintains its debt-equity ratio, what is the debt capacity of the project in part b?
The project’s debt capacity is equal to d times the levered value of its remaining cash flows at each date.
d = (14.4-10.8)/14.4 = 0.25
Problem 29-1 What inherent characteristic of corporations creates the need for a system of checks on manager behavior?
“The corporation allows for the separation of management and ownership. Thus, those who control the operations of the corporation and how its money is spent are not the same who have invested in the corporation. This creates a clear conflict of interest and this conflict between the investors and managers creates the need for...