Consider a firm F with the following features:

• EBIT is 200 at time 1. Then, EBIT grows at a 1% annual rate (perpetuity).

• Regardless of firm F s leverage, firm F s probability of default is zero.

• Regardless of firm F s leverage, the covariance between firm F s stock return and the market return is 0.01.

• The corporate tax rate is 20%.

• The expected market return is 10%. The volatility of the market return is 15%. The risk-free rate is 2%. The so-called Weighted Average Cost of Capital (WACC) is defined as follows:

  WACC= S rS+ B (1Tc)rB= 1 rS+ L (1Tc)rB, S+B S+B 1+L 1+L

  where B is the firms debt, S is the firms equity, L = BS is the firms leverage, rS is the firms cost of equity, rB is the firms cost of debt, and Tc is the firms corporate tax rate.

  (a) (2 points) Compute the Weighted Average Cost of Capital (WACCF1) when firm Fs leverage is L = 1.

(b) (2 points) What is todays value of firm F (AF1 ) if firm F s leverage is L = 1? Hint: 1) Compute the cash-flows to the shareholders of a comparable (exact same features as F except the capital structure) unlevered firm. 2) Assume that discounting these cash-flows at the WACC provides the value of the firm.

(c) (2 points) Compute the Weighted Average Cost of Capital (WACCF2) when firm Fs leverage is L = 2.

(d) (2 points) What is todays value of firm F (AF2 ) if firm F s leverage is L = 2? Hint: 1) Compute the cash-flows to the shareholders of a comparable (exact same features as F except the capital structure) unlevered firm. 2) Assume that discounting these cash-flows at the WACC provides the value of the firm.