Question 1.

The XYZ Company has a current market value of Kshs.1000000, half of which is debt. Its current weighted average cost of capital is 9%, and the corporate tax rate is 40%. The treasurer proposes to undertake a new project, which costs Kshs.500000 and which can be financed completely with debt. The project is expected to have the same operating risk as the company and to earn 8.5% on its levered after-tax cash flows. The treasurer argues that the project is desirable because it earns more than 5%, which is the before-tax marginal cost of the debt used to finance it. What do you think?

Question 2

The Modigliani-Miller theorem assumes that the firm has only two classes of securities, perpetual debt and equity. Suppose that the firm has issued a third class of securities (preferred stock) and that X% of preferred dividends may be written off as an expense (0 X1).

a) What is the appropriate expression for the value of the levered firm? b) What is the appropriate expression for the weighted average cost of capital?