Assume a textbook Modigliani-Miller world: there are
(i) no taxes, (ii) no bankruptcy costs, (iii) no conflicts of interest between
bondholders, shareholders and managers, and (iv) firms know their future
financing needs. You are looking at a firm with operating cash flows that have
a beta of 1.2. The market risk premium is 6% and the risk free rate is 3%. The
firm is currently all equity financed but it can borrow as much as it wants at
3%, i.e., for simplicity we assume that the debt is risk free — there is no
bankruptcy risk.

(a) Compute the cost of equity and the WACC for the
firm as is (all equity).

(b) Compute the cost of equity and the WACC for the
firm, assuming it recapitalizes such that debt becomes 10% of the capital
structure.

(c) Repeat part (b) for debt ratios of 20%, 30%, …,
90%. How does the WACC change as leverage changes? Can you explain the pattern
using the concepts we have discussed in class?

(d) Now assume that the firm
faces a tax rate of 38%. Compute the cost of equity and the cost of capital for
debt ratios 0%, 10%, …, 90%. How does the WACC change as leverage changes? Can
you explain the pattern using the concepts we have discussed in class