Question Five

The balance sheet of a company consists of assets with a value of 200m, debt with a value of 90m, and equity with a value of 110m. The risk-free rate is 3%, and the average return on the market index is 7%. You should assume that Modigliani-Miller's irrelevance of capital structure holds for questions a) and b). Answer the following questions:

1. The beta of the debt is 0.2, and the beta of the equity is 1.4. What is the weighted average cost of capital for the firm? (10 marks)

2. Suppose the firm rebalances its borrowing by issuing 10m more in debt used to buy back 10m worth of equity. The beta of the debt remains at 0.2 after the recapitalization. What is the new beta of the equity? (10 marks)

3. Explain why trade-off theory and pecking order theory predict that capital structure matters. (10 marks)