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Consider a firm that operates in a perfect capital market. At date 1 the firm generates either a cash flow of 1700 or a cash flow of 500. The cash flow depends on whether the economy is in a good state or a bad state. Both scenarios are equally likely. Assume further that the unlevered cost of capital of the firm is 10% and the risk-free rate is equal to 3%.
A) How much risk-less debt can the project support at date 0?
B) Compute the cost of debt for the following initial capital structure: At date 0, the value of equity is equal to E0 = 500 and the value of debt is equal to D0 = 500. What is the corresponding cost of equity? What is the firm’s WACC?
C) Compute the cost of debt for the following initial capital structure: At date 0, the value of equity is equal to E0 = 200 and the value of debt is equal to D0 = 800. What is the corresponding cost of equity? What is the firm’s WACC?
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