1. The expected rate of return on the common stock of an unlevered firm is 10%. The expected return on debt is 5%. According to MM Proposition 2, whats the expected rate of return on the common stock of a levered firm if the market value of debt is $300,000 and market value of equity is $500,000. Please show all your work to derive the final answer to get full credit. [1 point]

2. The market-value balance sheet and other financial data for Company XXX are listed below.

Asset value $1,200,000 Debt $300,000

Equity $900,000

$1,200,000 $1,200,000

Cost of debt 6%

Cost of equity 12%

Marginal tax rate 21%

The financial manager of company XXX is considering a project that requires $50,000 investment today and expects to generate a perpetual earnings and cash flow of $5,000 each year (pre-tax). Assume no depreciation. However, the project supports only 40% debt, which is different from the debt ratio of company XXX overall. Calculate NPV of the project by adjusting WACC of the project. (keep four decimals including percentage to avoid rounding error). [4 points]

3. Following Q2, the financial manager of company XXX is tempted to acquire company YYY. Company YYY is a private company without stock market price. However, it is in the same line of business as company XXX, you can assume it has the same business risk. The following table sets out the information that you need to forecast company YYYs free cash flows (the highlighted numbers are all forecasted numbers). You can assume the cash flow in year 0 has already occurred when you calculate the value of the business. Value horizon is 3 years. From year 4 onward, you assume a long-term growth rate of 3% each. Now assume Company XXX plans to finance the purchase with $30,000 of debt. It intends to pay down the debt to $22,234 in year 3 so that the debt ratio at the horizon is 25%, the normal debt ratio of company XXX.

	0	1	2	3	4
Sales	70000	71000	72000	73000	74000
Cost of goods sold	56000	56800	57600	46080	59200
Net working capital	10000	10142	10286	10429	10571
Depreciation	3000	4000	4000	4000	4000
Gross fixed assets	60000	65000	70000	76000	82000
Debt	30000	28000	25000	22234
Investment in fixed assets (change in gross fixed assets)	7000
Investment in working capital	300

You will use APV method to calculate the value of company YYY (keep four decimals). Show are your inputs to get full credit.

(a). Whats profit after tax in year 2? Show your inputs to get full credit. [0.5 point]

(b). Whats free cash flow in year 2? Show your inputs to get full credit. [1 point]

(c). Whats after-tax WACC and cost of capital of company XXX? [1 point]

(d). Whats horizon value (not the present value)? [1 point]

(e). Whats the base-case PV of company? Whats the PV of interest tax shields? Whats the PV of company YYY? [1.5 point]