santa fe pacific a major rail operator with diversified operations had earnings befo 546294

Santa Fe Pacific, a major rail operator with diversified operations, had earnings before interest, taxes and depreciation, of $637 million in 1993, with depreciation amounting to $235 million (offset by capital expenditure of an equivalent amount). The firm is in steady state and expected to grow 6% a year in perpetuity. Santa Fe Pacific had a beta of 1.25 in 1993 and debt outstanding of $1.34 billion. The stock price was $18.25 at the end of 1993, and there were 183.1 million shares outstanding. The expected ratings and the costs of debt at different levels of debt for Santa Fe are shown in the following table (The treasury bond rate is 7% and the firm faced a tax rate of 40%.).

D/(D+E) Rating Cost of Debt (Pre-tax)

The earnings before interest and taxes are expected to grow 3% a year in perpetuity with capital expenditures offset by depreciation. (The tax rate is 40%, the treasury bond rate is 7% and the market risk premium is 5.5%.)

a. Estimate the cost of capital at the current debt ratio.

b. Estimate the costs of capital at debt ratios ranging from 0% to 90%.

c. Estimate the value of the firm at debt ratios ranging from 0% to 90%.