Q 17.27. A firm will earn a taxable net return of $500 million next year. If it took on debt today, it would have to pay creditors &(Debt) = 5% +10% webt (The increasing cost of interest may be the case for different reasons, covered in the next chapter.) Thus, if the firm has 100% debt, the financial markets would demand 15% expected rate of return. Further, assume that the financial markets will lend the firm capital at this overall net cost of 15%, regardless of how the firm is financed. The firm is in the 25% marginal tax bracket.

1. If the firm is fully equity-financed, what is its value? 2. Using APV, if the firm is financed with equal amounts of debt and equity today, what is its value? 3. Using WACC, if the firm is financed with equal amounts of debt and equity today, what is its value? 4. Does this firm have an optimal capital structure? If so, what is its APV and WACC?