Question: Conglomerate Enterprises has grown rapidly by acquiring other firms. It is currently negotiating to take over Northern Manufacturing. Northern Manufacturing's capital structure consists of 20 percent debt and 80 percent equity, and the beta on its common stock has been estimated at 1.2. Northern's tax rate is 40 percent. The interest rate on long-term government debt is 14 percent, and Northern can borrow at this same rate. The expected return on the market is 20 percent. Conglomerate believes that Northern's financing mix is too conservative and plans to change Northern's capital structure to 40 percent debt and 60 percent equity. For simplicity, assume that any new shares can be sold at their prevailing market price, so that
(a) What is Northern's beta and its cost of equity after the proposed change in capital structure?
(b) What is Northern's weighted average cost of capital both under the original and the proposed new capital structure?
(c) Plot Northern's beta, cost of equity, and weighted average cost of capital as a function of its debt-to-equity ratio and briefly explain your findings. What assumptions are implied in your results?