Question 3 (15 Marks)

DEF corporation is currently an all-equity. It needs to raise $2.5 million in additional funds. After raising the funds, it expects earnings before interest and taxes to be $600,000. The firm's unlevered cost of equity, Ku, is 12% and it's before-tax cost of debt, Kd, is 8%.

Required

Part A

1.If there are no corporate taxes, in a perfect M&M world, what is the value of DEF if it issues common shares to raise the needed?

2.Alternatively, what is the firm's new cost of equity and the value of the firm if it issues debt to raise the needed funds?

3.What is the opportunity cost of capital (WACC) for both scenarios 1. And 2. Above?

4.Wat is the fundamental determinant of the value of the firm in the M&M no tax case?

Part B - Now assume that the corporate tax rate is 35%

1.What is the all equity value of DEF?

2.What is DEF's value if $2.5 million in debt is issued? What is the new KeL? What is the new opportunity cost of capital?