Question

A firm has the following capital structure: 100 million shares outstanding, trading at £1.5 per share, and £100 million of debt. The beta of the firm’s stock is 1.5. The firm’s cost of equity is 10 percent, and the yield on riskless bonds is 2.5 percent. There is no tax. Assuming that the firm can borrow at the risk free rate and that both CAPM (Capital Asset Pricing Model) and the Modigliani-Miller theorem hold, answer the following questions. i) What is the total value of the firm? ii) What is the WACC of the firm? iii) What should be the expected return on the market portfolio? iv) Suppose the firm changes its capital structure so that its debt increases to £150 million, and the equity decreases by £50 million. What should be the firm’s cost of equity after the change?

Answer 1

ANSWER: Total value of the firm value of equity + value of debt total value of the firm = (100 x 1.5) + 100 = 250 (150/250)*(10%) + (100/25°)" (2.5)-7.00% Ke- Rf+beta(Rm.Rf) 10%-: 2.5% + 1.5(Rm.2.5%) 7.5%-1.5( Rm-2.5%) 5%- (Rm-2.596) 7.5%= Rm RETURN ON MARKET PORTFOLIO f Debit is increaserto 150 WACC wont tochange as per MM approach 40/250,-5%)+(150/250)"(2.5%) 7%- 7% = 5.5% = Ke- (1 0.4* Ke + 1.5 0.4*Ke 13.75%