This preview shows pages 1–3. Sign up to view the full content.
This preview has intentionally blurred sections. Sign up to view the full version.
View Full Document
Unformatted text preview: FIN340 HOMEWORK #5 SOLUTION 1. Leverage Inc. a) Market risk premium is 9% ( = 13%  4% ). b) The firms cost of equity is currently 16.6% ( = 4% + 1.4 9% ). c) The portion of the cost of equity attributable to the firms 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 firms 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 firms 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....
View Full
Document
 Spring '09
 Narg

Click to edit the document details