Question

This information applies to the following set of questions. Steady State Inc. (SSI) is a profitable company that has stayed the same size for the past few years (as measured by its Balance Sheets, Income Statements and Cash Flow Statements). You expect SSI to maintain this steady-state condition into perpetuity, except for possible changes to its capital structure This simple firm has no accruals, no PPE or etc, so for any given year its NI = FCF to owners. The firm is debt free. Given the below data, find (as requested) SSI's optimum WACC, rE, rD and D/(D+E) ratio. Choose among the three cases listed. Annual Income Statement $MM UON Notes $193.60 Revenue ($154.88) $0.00 $38.72 - SGA Company is debt free. -Interest %3DЕВT ($17.42) $21.30 - Tax = NI NI because of no accruals, PPE, etc. $21.30 FCFE FCF Rates and other constants 4.00% RF 7.00% Гм Bu 1.10 Trate 45.00% Variable Ratios and Rates Case 2 D/(D E) WD 0.0% 80.0% 45.00% 0.00% 7.50% 14.00% 9.00% 11.00% 18.00%

A. What is the firm's WACC for Case 1? case 2? case 3?

B. Which case corresponds to the optimal WACC (case 1, 2, or 3)?

C. What is the corresponding D/(D+E) ratio (75%, 30%, 9%, 0%, 45%, 20%, 60%, 55%)?

D. Why does minimum WACC correspond to an entity's optimum leverage for all stakeholders?

--Minimum WACC maximizes the present value of each future cash flow.

--Minimum WACC minimizes the project's negative cash flows.

--Minimum WACC corresponds to an optimal D/(D+E) ratio

-- Minimum WACC drives down the present value of negative cash flows

Answer 1

1) WACC = wd x rd x (1 - tax) + we x re

= 0% x 0% x (1 - 45%) + 100% x 9%

= 9%

2) WACC = 45% x 7.5% x (1 - 45%) + 55% x 11% = 7.91%

3) WACC = 80% x 14% x (1 - 45%) + 20% x 18% = 9.76%

4) Option 2 corresponds to optimal WACC as it is the minimum.

5) D/(D + E) = 45%

6) a is correct.