Nero Violins has the following capital structure:

Security Beta Debt 0 Equity 1.2

Total market value (millions of dollars) 100 200

Assume no taxes or costs of financial distress.

(a) Assume the CAPM is correct. What discount rate should Nero use to evaluate projects similar to its current projects (that is, what discount rate should Nero use to expand the scale of its investments)? Assume that the riskfree rate is 5%, and that the expected return on the market is 13%.

(b) Now assume that Nero decides to issue an additional $100 million of equity and used the cash to repurchase all the debt. How does Neros equity beta change? How does the Neros discount rate change? Explain your answer.