HW3.dvi

Consider a simple firm that has the following market-value balance sheet:

Assets Liabilities & Equity

$1, 000 Debt $400 Equity $600

Next year, there are two possible values for its assets, each equally likely: $1,200 and $960. Its debt will be due with 5% interest. Because all of the cash flows from the assets must go either to the debt or the equity, if you hold a portfolio of the debt and equity in the same proportions as the firms capital structure, your portfolio should earn exactly the expected return on the firms assets. Show that a portfolio invested 40% in the firms debt and 60% in its equity will have the same expected return as the assets of the firm. That is, show that the firms WACC is the same as the expected return on its assets.