Hollis, Inc. has no debt outstanding and the cost of capital for the firm is 10%. It is considering adding debt to the capital structure. They aim for a capital structure of 10% debt, and 90% equity at first. The borrowing rate is 4%.

a) Assuming no taxes, what is Hollis cost of equity under the new capital structure? What is the weighted average cost of capital? What theory does this demonstrate?

b) Assuming that the corporate tax rate for Hollis is 35%, calculate the cost of equity and the weighted average cost of capital under the new capital structure scenario. What theory does this demonstrate?

c) What is the implication in parts a and b to firm value under different debt-to- equity ratios