The risk-free rate is 3%, and the average return on the market portfolio is 7%. Answer the following questions:

1. A company has a debt-equity ratio of 2. The equity has a beta of 1.5. The debt has a yield-to-maturity of 4%. What is your estimate of the companys weighted average cost of capital? (10 marks)
2. The firm in question (a) reduces its borrowing so that the debt-equity ratio reduces to 1. The yield-to-maturity of the debt remains at 4%. If Modigliani-Millers irrelevance of borrowing holds, what is the cost of equity capital now? (10 marks)
3. Explain why the pecking order theory predicts that leverage is not irrelevant. Why do you think this theory predicts that highly profitable firms are likely to borrow less than other firms? (10 marks)