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"A friend is the one who walks in when the rest of the world walks out." - Jod

Dixon Corporation

  • Date Submitted: 10/08/2012 12:48 PM
  • Flesch-Kincaid Score: 62.9 
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Start with the basic WACC equation:
WACC = (E/D+E) x Re + (1-t) x (D/D+E) x Rd
Break down WACC into smaller components:
Exhibit 7 provided “Profit after taxes” (Net Income), earnings per share, and closing stock price for 1979 (expected).   We used the debt structure of the project to determine the debt ratio.   By taking on debt of $8M and using $4M in equity, we arrive at a 66.6% debt and 33.3% equity structure.
Cost of Equity (Re) can be determined using historical equity returns for the firm, CAPM, or APT.   We chose to use the CAPM.   We assumed:
- Market risk premium = 8%
- Risk-free rate of 9.5% (long-term treasury bonds at that time).  
- Estimated a corporate tax rate of 48% (AVG effective tax rates from 1975-1978)
1975 1976 1977 1978 1979
Operating income $2,366.00 $ 3,925.00 $ 4,741.00 $ 6,170.00 $ 7,842.00
Taxes $1,125.00 $ 1,878.00 $ 2,285.00 $ 2,932.00 $ 3,818.00
Net income $1,241.00 $ 2,047.00 $ 2,456.00 $ 3,238.00 $ 4,024.00
Effective tax rate 47.5% 47.8% 48.2% 47.5% 48.7%
Average effective tax rate 48.0%

We need the equity beta for Dixon.   Unlevering the betas for two comparable companies and re-levering with Dixon’s debt to equity structure.   This resulted in a re-levered beta of 2.22%.   Total cost of equity is 27.3%.  
The last component of the WACC to calculate is the cost of debt (Rd).   Multiply the interest rate of the bonds that were issued to raise capital (11.25%) by (1-t) – 48% tax rate.   After tax cost of debt (Rd) is estimated at 5.85%.   Plugging these into the WACC formula, we arrived at a weighted average cost of capital of 13%.
WACC = (E/D+E)Re+(D/D+E)(1-T)Rd Actual
E/D+E 33.3%
Re 27.3%
D/D+E 66.7%
T 48%
Rd = Dinterest (1-t) 11.25%
WACC 13.0%
 
2) What are the projected incremental cash flows associated with the acquisition of theCollinsville plant without the laminate technology? Use projections from Exhibit 8through 1984. After 1984 assume: EBIT is...

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