Arbitra Inc.s current capital structure is 30% debt and 70% equity. The expected return on its debt is 5%, its equity Beta is 1.1. The riskfree rate is 2%, and the expected return on the market is 10%. Consider first (in questions (i) and (ii)) the case of perfect capital markets.

1. a) Calculate Arbitra Inc.s asset Beta and its cost of capital (that is, Arbitra Inc.s expected return on assets).

2. b) Arbitra Inc. now decides to change its capital structure to 50% debt and 50% equity; as it does so, its total assets are not affected, but its debt becomes riskier and the debt Beta increases to 0.6. Calculate the firms expected return on equity under this new capital structure.

Consider now the following additional information. The government of Bigland, where Arbitra Inc. is located, introduces a 40% corporate income tax rate. Arbitra Inc. (capital structure still 50% debt and 50% equity) has only one project which is expected to generate $1000 of EBIT next year, at which point the firm will shut down.

c) Calculate Arbitra Inc.s firm value using the WACC method. Given the firm value you calculated, calculate the value of the firms debt.

d) Calculate Arbitra Inc.s firm value using the APV method and show that this gives the same answer as in (iii). Hint: To show this, you need to first explicitly calculate the interest tax shield; for the calculation of the present value of the tax shield, use the expected return on the firms assets.