1. Johnson Company is financed by a mixture of debt and equity. You have the following information about its cost of capital: rD= 12%, rf= 10%, rm= 18%, βE= 1.5, D/V= 0.5. We apply MM’s assumptions and no taxes.
(1) Compute rE by CAPM (or SML). 22%
(2) Compute βD by CAPM (or SML) because theoretically every security should locates on SML. 0.25
(3) Compute rA by WACC. 17%
(4) Compute βA as the weighted average of βD and βE. 0.875
Continue from the previous question. Suppose now that Johnson Company repurchases debt and issues equity so that D/V= 0.3. The reduced borrowing causes rD to fall to 11%. What is rA and βA now? Compute rE, βD, and βE again. [Hint: Do not follow the order in the previous question. Follow the concept from the MM’s Proposition II. Fix rA first, then compute rE by the MM’s Proposition II. Use CAPM (or SML) to compute β’s by new required returns solved in this question.]
Show your work.