XYZ Ltd is currently all equity financed with a market value of $1 million. Its management is

considering the issue of bonds with a face value of $500,000 (issued at face value). The new funds

raised will be used to repurchase shares from existing shareholders.

a) Illustrate the effect of leverage in a world with no taxes by sketching the relationship between

the cost of equity and leverage for the all equity situation and the proposed (50% debt, 50%

equity) on a fully labeled graph.

All firms face business risk. What additional risk do shareholders face under the proposed

structure? Illustrate the second of these two risks by rearranging the weighted average cost of capital equation