Problem #2 (12 marks)

Morrison Medical Inc., an all-equity firm, has earnings before interest and taxes of $950,000, an un-levered beta of .80 and a tax rate = 35%. In the market, you observe that Government T-bills are being sold to yield 2% and the S&P/TSX Composite Index is expected to yield 9%. Assume a world with taxes and no cost for the risk of default. All general M&M assumptions apply.

1. What is the market value of the firm? (2 marks)
2. What is the market value of the firm and the market value of the equity if they issue $5,000,000 in debt with a coupon rate of 4.5% and use the proceeds to repurchase shares? (3 marks)
3. What is the new cost of equity? (2 marks)
4. According to CAPM, what is the new beta? (1 mark)
5. What is the WACC? (2 marks)
6. Explain what happens to the market value of the firm and the WACC if the firm increases its debt-to-equity ratio. (2 marks)