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Unformatted text preview: FIN340 HOMEWORK #5 SOLUTION 1. Leverage Inc. a) Market risk premium is 9% ( = 13%  4% ). b) The firm’s cost of equity is currently 16.6% ( = 4% + 1.4 × 9% ). c) The portion of the cost of equity attributable to the firm’s business risk is given by R A . We therefore have to “unlever” R E = 16.6% using R E = R A + D/E × ( R A R D ) × (1  T C ) or, equivalently, 16.6% = R A + 1200/4800 × ( R A 10%) × (1  30%) , where the value of equity is given by E = 4 × 1200 = 4800. Simplifying and solving for R A yields 15.62%. d) The portion of the cost of equity attributable to the firm’s financial risk is formally given by + D/E × ( R A R D ) × (1  T C ) or, equivalently, by R E R A . It is therefore equal to 16.6%  15.62% = 0.98%. e) The weighted average cost of capital ( WACC ) is currently given by: WACC = E/V × R E + D/V × R D × (1  T C ) , which is equal to 14.68% after substituting in the above results with the weights E/V = 0.8 and D/V = 0.2. f) The firm’s new cost of equity is obtained by “relevering” R A = 15.62% up to the new debt/equity ratio. R E = R A + D/E × ( R A R D ) × (1  T C ) , This is in terms of numbers R E = 15.62% + 0.5 × (15.62%  10%) × (1  30%) , or R E = 17.58%. 1 g) The weighted average cost of capital ( WACC ) is now given by: WACC = E/V × R E + D/V × R D × (1  T C ) , which is equal to 14.06% after substituting in the above results with the weights E/V = 2/3 and D/V = 1/3. Remember that 1+D/E = V/E and hence E/V = 1/ (1+D/E) = 1/1.5 = 2/3 and D/V = 1 (1+D/E) = 1/1....
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 Spring '09
 Narg
 Finance, Weighted average cost of capital, rd

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