Week 10 Tutorial Solutions

Week 10 Tutorial Solutions - Solutions Tutorial Week 10...

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Solutions – Tutorial Week 10 Chapter 18 15. a. Under Proposition I, the firm’s cost of capital (r A ) is not affected by the choice of capital structure. The reason the quoted statement seems to be true is that it does not account for the changing proportions of the firm financed by debt and equity. As the debt-equity ratio increases, it is true that both the cost of equity and the cost of debt increase, but a smaller proportion of the firm is financed by equity. The overall effect is to leave the firm’s cost of capital unchanged. b. Moderate borrowing does not significantly affect the probability of financial distress, but it does increase the variability (and market risk) borne by stockholders. This additional risk must be offset by a higher average return to stockholders. 19. We begin with r E and the capital asset pricing model: r E = r f + β E (r m – r f ) = 0.10 + 1.5 (0.18 – 0.10) = 0.22 = 22.0% Similarly for debt: r D = r f + β D (r m – r f ) 0.12 = 0.10 + β D (0.18 – 0.10)
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This note was uploaded on 08/22/2011 for the course FINC 2011 taught by Professor Craigmellare during the Three '10 term at University of Sydney.

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Week 10 Tutorial Solutions - Solutions Tutorial Week 10...

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