The Ex Nihilo Corporation has a debt-equity ratio of 0.5. Details of the balance sheet are given in Table 3.

Table 3: Ex Nihilo Cos balance sheet (market values, numbers in millions)

Assets

Liabilities

Fixed Investments 18,000

Debt ?

Equity ?

The beta of Ex Nihilo Cos fixed investments is 1.5. The risk-free rate is 3% and the average return on the market index is 7%.

(a) What is Ex Nihilo Cos weighted average cost of capital (WACC)?

(b)What are the values of Ex Nihilo Cos debt and equity?

(c) Ex Nihilo Cos cost of borrowing is 3.5%. What is Ex Nihilo Cos cost of equity capital?

(d) Assuming that Modigliani-Miller's irrelevance of borrowing policy holds, what would the cost of Ex Nihilo Cos equity be if the debt-equity ratio increases to 1.0? You should assume that the increase in borrowing increases the cost of borrowing to 3.6%.

(e) Explain the trade-off theory of borrowing.