Homework_5_Solutions

# Homework_5_Solutions - Homework#5 Solutions FIN340 FALL...

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1 Homework #5 Solutions FIN340 – FALL 2006 Professor Gormley, [email protected] Distributed: November 14th, 2006 Due: Tuesday, November 21 st , 2006 [in class] Note: Please show all work and circle your final answer to make grading easier. Homework Assignments may be done in groups of up to four students. 1. Leverage Inc. has \$1,200 debt. The cost of debt is 10%. Its current stock price is \$4 with 1,200 shares outstanding. The equity has a beta of 1.4. The expected return on the market portfolio is 13% and the risk-free rate is 4%. Suppose the corporate tax rate is 30%, but there are no other market imperfections. a. What is the firm’s cost of equity? Using the CAPM model… ! " ! " 0.04 1.4 0.13 0.04 16.6% e f E m f e e r r r r r r # \$ % \$ % \$ b. What portion of the cost of equity is attributable to the firm’s business risk? What portion is attributable to financial risk? From M&M Proposition II with Taxes, we know… ! "! "! " / 1 e U U d C r r r r D E T \$ % Where U r is the portion of the cost of equity due to “business risk” and ! "! "! " / 1 U d C r r D E T is portion due to the “financial risk”. Or, equivalently, the “financial risk” is also just equal to e U r r . Solving for U r , we have:

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2 ! "! "! " ! " ! " ! "! " / 1 0.166 0.10 1200/ 4 1200 1 0.30 0.166 1.175 0.0175 15.62% e U U d C U U U U r r r r D E T r r r r \$ % \$ % \$ \$ Thus, the business risk = 15.62% The financial risk = r e – r U = 0.98% c. What is the weighted average cost of capital (WACC)? ! " ! " 1 4800 1200 0.166 0.10 1 0.30 1200 4800 1200 4800 14.68% e d C E D WACC r r T D E D E WACC WACC ( ) ( ) \$ % * + * + % % , - , - ( ) ( ) \$ % * + * + % % , - , - \$ Now suppose that Leverage Inc. repurchases stock and finances the repurchase with debt so that its new debt-to-equity ratio changes to D/E = 0.5 d. What is the firm’s new cost of equity? Explain in 1-2 sentences why it increases because of the increase in leverage. There are a couple ways we could solve this. One way would be
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## This note was uploaded on 09/21/2009 for the course B 340 taught by Professor Narg during the Spring '09 term at Washington University in St. Louis.

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Homework_5_Solutions - Homework#5 Solutions FIN340 FALL...

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