Question: Nucor, an innovative steel company, has had a history of technical innovation and financial conservatism. In 1995, Nucor had only $ 210 million in debt outstanding (book as well as market value), and $ 4.2 billion in market value of equity (with a book value of $ 1.25 billion). In the same year, Nucor had earnings before interest and taxes of $ 372 million, and faced a corporate tax rate of 36%. The beta of the stock is 0.75, and the company is AAA rated (with a market interest rate of 6.80%).
a. Estimate the return differential between return on equity and cost of equity at the current level of debt.
b. Estimate the return differential at a debt ratio of 30%, assuming that the bond rating will drop to A-, leading to market interest rate of 8.00%.