Assume a world with corporate taxation but no personal taxation and where all the assumptions underlying the Mean-Variance Capital Asset Pricing Model hold. Consider two firms, A and B, which are identical in every respect except that A is all equity while B is levered and maintains a target value of debt to equity ratio of two. The assets of both firms have the same distribution of net operating cash flows each time period for an infinite number of time periods. The expected perpetual net operating income, E(NOI), for each firm is $200. The before-tax cost of debt, R_d, is the same as the risk-free rate.

The corporate tax rate tc is 0.25. The expected rate of return on the market portfolio, E(Rm), is 0.11; the variance of return on the market portfolio, ²_m is 0.0144; the risk free R_f is 0.06; the systematic risk of As equity is _A = 1.75

Note: The systematic risk of an unlevered company, U, and the systematic risk of the equity of a levered company, L, are related by

if the companies are identical apart from capital structure. D and E denote the value of debt and equity of the levered firm.

a) Determine the cost of capital and value of each firm.

b) Both companies are considering a project which would cost $950 the first year and then earn an expected net cash flow of $100 per year in perpetuity, on an after-tax basis. The investment managers of both A and B discover that company C which is in the same product line as the project and hence has the same risk as the project has risk free debt, an equity beta of 1.3, and debt/market value of firm ratio of 0.33. Should either company accept the project?

B = By [1+(1-13) B = By [1+(1-13)