Answer Happy

6. (5 points) In t = 0, Spallo Inc. is an unlevered company whose Beta is .5. The risk free-rate in the economy is 4%, and the market return is 8%. To begin with, assume that capital markets are perfect and Modigliani-Miller assumptions hold true. (a) Determine the required cost of equity using CAPM. (b) Given your answer in part (a), suppose that in t = 1 Spallo does a leveraged recapitalization, issuing risk-free debt and repurchasing stocks until its debt-equity ratio is 0.50. The rate of return on debt is 3% and the corporate tax rate is zero (7, = 0). i. Will the Beta of Spallo rise after the recapitalization? Explain why in max 2 lines. ii. Compute the Beta of Spallo's equity after the recapitalization. iii. What is the cost of equity of the levered firm? Briefly discuss your answer (max 2 lines). iv. Compute the WACC of the levered firm. (c) In t = 2, the government increases the corporate tax rate to 20%. If the debt-equity ratio is still 0.5, compute the (after-tax) WACC. (d) Given the government's decision in t 2, what should Spallo's optimal capital structure be?