fm17 16 - d is a constant 8 percent but r s increases with...

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Mini Case: 17 - 16 Now we can find L’s cost of equity, r sL : r sL = r sU + (r sU - r d )(D/S) = 14.0% + (14.0% - 8.0%)($1,000,000/$2,571,429) = 14.0% + 2.33% = 16.33%. We know from Proposition I that the WACC must be WACC = r sU = 14.0% for all firms in this risk class, regardless of leverage, but this can be verified using the WACC formula: WACC = w d r d + w ce r s = (D/V)r d + (S/V)r s = ($1,000/$3,571)(8.0%) + ($2,571/$3,571)(16.33%) = 2.24% + 11.76% = 14.0%. b. 2. Graph (a) the relationships between capital costs and leverage as measured by D/V, and (b) the relationship between value and D. Answer: Figure 1 plots capital costs against leverage as measured by the debt/value ratio. Note that, under the MM no-tax assumption, r
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Unformatted text preview: d is a constant 8 percent, but r s increases with leverage. Further, the increase in r s is exactly sufficient to keep the WACC constant--the more debt the firm adds to its capital structure, the riskier the equity and thus the higher its cost. Figure 2 plots the firm’s value against leverage (debt). With zero taxes, MM argue that value is unaffected by leverage, and thus the plot is a horizontal line. (Note that we should not really extend the graphs to D/V = 100% or D = $2.5 million, because at this amount of leverage the debtholders become the firm’s owners, and thus a discontinuity exists.)...
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