Perfect World Corp. is unlevered and is valued at $640,000. The company is currently deciding whether including debt in its capital structure would increase its firm value. The current cost of equity is 12%. One of its CFO's proposals is to issue $300,000 in new debt with an 8% interest rate. Perfect World would repurchase $300,000 of stock with the proceeds of the debt issue. There are currently 32,000 shares outstanding, and effective marginal tax bracket is zero. 1) What will be new firm value under the proposed capital structure? (5 marks)

2) So far, we have considered a situation in which taxes do not exist. From this "perfect world." we now add complexity to understand what is relevant to the capital structure decision. Assume that Perfect World Corp. is subject to an effective marginal tax bracket of 34%. What will be the company's new cost of equity? (2.5 marks) What will be the company's new WACC? (2.5 marks)

3) Is there any target amount of leverage for Perfect World according to the pecking order theory? (1 mark)

4) What type of market frictions has been considered in the pecking order theory but not in the trade-off theory? (2 marks)

5) Is the following statement true or false? One of the implications of the trade-off theory is that Perfect World Corp. will use less debt when it is more profitable. (2 marks)