CHAPTER 17

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Unformatted text preview: et pricing model: rE = rf + bE (rm ­ rf) rE = 0.10 + 1.5 (0.18 ­ 0.10) = 0.22 = 22.0% Similarly for debt: rD = rf + bD (rm ­ rf) 0.12 = 0.10 + bD (0.18 – 0.10) bD = 0.25 Also, we know that: To solve for bA, use the following: 12. We know from Proposition I that the value of the firm will not change. Also, because the expected operating income is unaffected by changes in leverage, the firm’s overall cost of capital will not change. In other words, rA remains equal to 17% and bA remains equal to 0.875. However, risk and, hence, the expected return for equity and for debt, will change. We know that rD is 11%, so that, for debt: rD = rf + bD (rm ­ rf) 0.11 = 0.10 + bD (0.18 ­ 0.10) bD = 0.125 For equity: 0.17 = (0.3 ´ 0.11) + (0.7 ´ rE) rE = 0.196 = 19.6% Also: rE = rf + bE (rm ­ rf) 0.196 = 0.10 + bE (0.18 ­ 0.10) bE = 1.20 13. Before the refinancing, Schuldenfrei is all equity financed. The equity beta is 0.8 and the expected return on equity is 8%. Thus, the firm’s asset beta is 0.8 a...
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