solve20 - FNCE 3010(Durham HW 20 capital structure 1 XYZ...

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FNCE 3010 (Durham). HW 20 - capital structure 1. XYZ Corp., is all equity financed. Its WACC is 11%. Suppose that it wants to issue some debt in order to expand its operations. It estimates that investors will require a 6% yield in order to hold this debt. After issuing the debt, its debt-equity ratio will be 0.5. The unleveraged firm has a beta of 1.2. (a) If we ignore taxes, what will the cost of equity be for the leveraged firm? What will its WACC be? What will its beta be? (b) If the tax rate is 34%, what will the cost of equity be for the leveraged firm? What will its WACC be? What will its beta be? Solution: (a) EM = 1.5, so R E = R D + EM · ( R A - R D ) = 6 + 1 . 5 · (11 - 6) = 13 . 5%. WACC = (1 / 3) · 6 + (2 / 3) · 13 . 5 = 11%, the same as the unleveraged firm. The beta of the levered firm is β L = 1 . 5 · β U = 1 . 5 · 1 . 2 = 1 . 8. (b) With taxes, we get, R L = R D + 1 + (1 - T ) · D L E L · ( R U - R D ) = 6 + (1 + . 66 · . 5) · (11 - 6) = 12 . 65% WACC = (1 / 3) · 6 · . 66 + (2 / 3) · 12 . 65 = 9 . 75 β L = β U · 1 + (1 - T ) · D L E L = 1 . 2 · (1 + . 66 · . 5) = 1 . 596 2. XYZ Inc., has expected cash flows of $500 per year forever. The firm is com- pletely equity financed and has a beta of 0.9. The tax rate is 34%, the risk-free
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