Illustrate weighted average cost of capital for firm


Task: Use the appropriate MM model to evaluate the following: an unlevered firm (Firm U) has a market value of $45 million, a tax rate of 40%, and expected EBIT of $9 million. A levered firm (Firm L) is identical to Firm U (same tax rate, same EBIT) except Firm L has outstanding 8% debt of $18 million.

Q1. The weighted average cost of capital for Firm U is

a. 5.00%
b. 8.00%
c. 12.00%
d. 15.00%
e. 20.00%

Q2. The cost of equity for firm U is

a. 5.00%
b. 8.00%
c. 12.00%
d. 15.00%
e. 20.00%

Q3. The weighted average cost of capital for Firm L is

a. 8.00%
b. 10.34%
c. 12.00%
d. 17.24%
e. 18.00%

Q4. The cost of equity for firm L is

a. 8.00%
b. 11.25%
c. 12.00%
d. 13.26%
e. 16.85%

Q5. The market value of Firm L is

a. $65,000,000
b. $63,000,000
c. $52,200,000
d. $18,000,000
e. $ 9,000,000

Q6. Has Firm L benefited from the use of leverage? Why or why not?

a. Yes because VL > VU
b. No because VL > VU
c. Yes because rAL > rAU
d. No because rAL > rAU
e. In fact, only answers (a) and (c) are correct

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Finance Basics: Illustrate weighted average cost of capital for firm
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