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Capital Structure and Leverage 31

Capital Structure and Leverage 31 - firm’s tax rate is 40...

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Old Exam Questions - Capital Structure and Leverage Page 31 of 31 Pages Assuming that the firm now triples its debt/equity ratio, and using the Hamada equations to relever the firm’s beta, determine what the firm’s new cost of stock will be. A. 10.80% B. 10.00% C. 9.20% D. 10.40% E. 9.60% 59. We discussed in class how the return on equity for a levered firm can be a function of the return on assets of an equivalent unlevered firm, a leverage effect, and a tax shelter effect. Assume that a firm starts out as an all equity firm with \$5,000,000 of common equity, \$5,000,000 of assets, and a return on assets (ROA) of 12 percent. Also assume that management makes the decision to issue \$1,000,000 of preferred stock (the firm’s cost of preferred is 8 percent), and to then use the proceeds to buy back \$1,000,000 of common equity. Based on this information, and assuming that the
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Unformatted text preview: firm’s tax rate is 40 percent, determine what the return on equity (ROE) will be after the buy back. A. 12.00% B. 12.50% C. 13.00% D. 13.50% E. 14.00% 60. Assume that the risk-free rate is 4.00 percent, the return on the market is 8.00 percent, the tax rate is 40 percent, and that a firm’s cost of stock, using the CAPM/SML, is 8.80 percent [HINT: you should now be able to determine the firm’s levered beta.] Also assume that the firm’s unlevered beta has a value of 1.00 [HINT: you should now be able to use the Hamada equations to back out the firm’s current debt/equity ratio.] Assuming that the firm now doubles its debt/equity ratio, and using the Hamada equations to relever the firm’s beta, determine what the firm’s new cost of stock will be. A. 10.80% B. 10.00% C. 9,20% D. 10.40% E. 9.60%...
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