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Page 5 of 7 ECON41315WE01 SECTION II. Answer ONLY ONE of the following exercises. Please clearly show the steps leading to your final answer. The marks for each question in the exercises are shown separately. I. OPTION A –COST OF CAPITAL Use the following information to answer the question(s) below.Consider the following information regarding several companies and corporate bonds: Rating AAA AA A BBB BB B CCC Average Default Rate 0.0% 0.1% 0.2% 0.45% 2.2% 5.5% 12.2% Recession Default Rate 0.0% 1.0% 3.0% 3.0% 8.0% 16.0% 48.0% Average Beta 0.05 0.05 0.05 0.10 0.17 0.26 0.31 Company Market Capitalization (£mm) Total Enterprise Value (£mm) Equity Beta Debt Rating Taggart Transcontinental £4,500 8,000 1.1 BBB Rearden Metal £3,800 7,200 1.8 AAA Wyatt Oil £2,400 3,800 0.9 A Nielson Motors £1,500 4,400 1.75 BB 1. What would be your estimate of the debt beta for Taggart Transcontinental? (5 marks) 2. What would be your estimate of the asset beta for Taggart Transcontinental if you assume corporate tax rate is zero? (10 marks) 3. Suppose that because of the large need for steel in building railroad infrastructure, Taggart Transcontinental and Rearden Metal decide to form into one large conglomerate. What would be your estimate of the asset beta for this new conglomerate? (5 marks) 4. Taggart has a portfolio of projects yet to be assessed. Entering the conglomerate implies every single project in that portfolio has to be developed by the conglomerate and not by Taggart itself. Assume Taggart’s good relationship with its debtors guarantees the conglomerate will have access to debt at the same cost as Taggart’s.The conglomerate will also target Taggart’s capital structure. From a corporate finance perspective, briefly discuss what could Taggart’s managerexpect to happen with the number of projects actually developed by the conglomerate and explain the concept on which this expectation is based. (10 marks)
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