Scenario 1: Assume that you are in the world of Modigliani and Miller where there are no market imperfection such as taxes, transaction costs and information asymmetry. You have set up an all equity business. The value of your company is $1 million. Return on equity of your business is 10%. Scenario 2: However, you plan to reduce the equity holding from your business and introduce debt. You are planning to take a loan of $350,000 from the bank. The value of your business remains $1 million. The interest rate on the loan is 7%. Scenario 3: Now assume that you are no longer in the Modigliani and Miller world. That is, there are taxes and other market imperfections. The tax rate is 30%. All other information is same as per Scenario 2.

What are the weighted average cost of capital in Scenario 1?

ii) Is the return on equity in Scenario 2 higher or lower than that in Scenario 1? Explain clearly.

iii) What is the weighted average cost of capital in Scenario 2?

iv) What is the cost of capital in Scenario 3? Is it higher or lower than Scenario 2? Explain?