Question 1 a. Kappa is an all-equity firm. It has 120,000 shares outstanding, currently worth 20 per share. The unlevered cost of equity is 20%. The firm has decided to issue 1,000,000 of 8% debt, and to use the proceeds to repurchase shares. Assume a 28% corporate tax rate.

i. According to Modigliani-Miller Proposition I with corporate taxes, what is the market value of the firms equity after the repurchase? (6 marks)

ii. What are the firms earnings before interest and taxes? (Assume that earnings are cash flows.) (6 marks)

iii. What is the return on equity after the change in the firms capital structure? (7 marks)

iv. What is the value of a share after the capital structure change? (10 marks)

AND b. Discuss the factors favoring a high-dividend policy. (12 marks)

AND c. Stock A has an expected return of 5% and a standard deviation of 10%. Stock B has an expected return of 10% and a standard deviation of 20%. The covariance between the returns of the two stocks is 0.001. Suppose an investor holds a portfolio consisting of only stock A and stock B. Find the portfolio weights, XA and XB, such that the variance of her portfolio is minimized. (9 marks)