Suppose we are analyzing Firm X. Firm X is financed with both equity and debt and will exist for only one year. If the economy is good, the equity holders will receive $220,000. If the economy is poor the equity holders will receive nothing. The debt holders will receive a payment of $65,000 regardless of the economy (i.e. there is no possibility of default). There are no other possible outcomes. Each of the two possible outcomes is equally likely. The beta of the equity is 2.12. The risk-free rate is 5%, and the market risk premium is 4%. Assume there are no taxes, no bankruptcy costs, information is held in common and that the firm’s investment policy is fixed. Also assume that the CAPM is true.
a.) What is the value of the firm’s equity?
b.) What is the value of the firm’s debt?
c.) What is the firm’s WACC?
d.) What would the cost of capital be if the firm was 100% equity?