Capital Structure and Leverage - Solutions2

# Capital Structure and Leverage - Solutions2 - 1 Your...

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Old Exam Questions - Capital Structure and Leverage - Solutions Page 6 of 59 Pages 1. Your company is financed entirely by common stock that is priced to offer a 15% expected/required return. If the company repurchases 25% of the common stock and substitutes an equal value of debt yielding 6%, what is the expected return on the common stock after refinancing? (Assume that you are in a Modigliani and Miller world without taxes.) A. 24% * B. 18% C. 15% D. 12% E. None of the above In this sort of M&M world, the average cost of capital will not change. Therefore, 15% = (.25)(.06) + (.75)(K e ) K e = (.15 - .015)/(.75) = 18% 2. Your company is financed entirely by common stock that is priced to offer a 20% expected/required return. Assume now that the company repurchases 30% of the common stock and substitutes an equal value of debt. If the cost of equity increases to 25.14%, then what is the interest rate on the debt? (Assume that you are in a Modigliani and Miller world without taxes.) * Since this is an M&M world without taxes, we know that the average cost of capital will remain at 20%. Therefore, .20 = (.30)(K D ) + (.70)(.2514) K D = [.20 - (.70)(.2514)] / [.30] K D = 0.08 3. The beta of an all equity firm is 1.0. If the firm changes its capital structure to 50% debt and 50% equity, using 8% debt financing, and if the tax rate is 40%, then what will be the beta of the equity of the levered firm? (You may assume that the beta for debt is zero.)

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Old Exam Questions - Capital Structure and Leverage - Solutions Page 7 of 59 Pages * Levered Beta = 1.0 + (1.0)(.50/.50)(1 - .40) = 1.6
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