A recent study of the US banking industry finds that ignoring tax effects, the Modigliani and Miller irrelevance proposition for capital structure holds for large US banks. In other words, banks weighted average cost of capital (WACC) is independent of leverage.

(a) TBTF Bank has assets to equity ratio of 16.0 (i.e., D+E E = 16.0) and an equity beta equal to 1.1. What is TBTFs WACC assuming the above study is correct? Assume a risk-free rate of 1.0% and a market risk premium of 8%. Ignore taxes and assume TBTFs debt is risk-free.

(b) If TBTF Bank were to issue new shares of equity to cut its assets to equity ratio in half (i.e., D+E E = 8.0), what is its new expected return on equity and new WACC?

(c) Repeat parts a and b assuming that TBTF Bank pays 26% in corporate taxes and that the interest payments on debt are tax-deductible.