he Weighted Average Cost of Capital Method

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?

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?

Year

0

1

2

3

FCF

−100

50

100

70

c. If Alcatel-Lucent maintains its debt-equity ratio, what is the debt capacity of the project in part b?