Testing Hypothesis

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Answers to Self–Check Test 11 Part A: Multiple Choice 1. c 2. c 3. e 4. d 5. e 6. c 7. a 8. d 9. a 10. d Explanations to selected multiple choice questions: 2. [pic] 4. [pic] 6. [pic] 7. The value of retained earnings is a part of the shareholder’s equity, and is reflected in the market value of equity. It should be included in the calculating the market value of equity. 8. All investors will receive their required rate of return. 9. As the WACC decreases due to the cost advantage of debt, the present value of the cash flows generated by the project will increase, consequently the NPV of the project will increase. 10. The lowest acceptable…show more content…
The firm is in the 35% marginal tax bracket. Using CAPM the required return on equity and the cost of equity is 18.05%. With an after tax cost of debt of 5.85%, WACC is 13.78% 11. Elwood & Jake Corporation is a publicly traded firm. The market value of its equity is $35,000,000 and its debt $15,000,000. The yield to maturity of the debt is 5%, the equity–holders require a 20% return, and the company pays 30% corporate tax. They have recently decided to repurchase $5,000,000 worth of equity, and finance the repurchase through the issuance of new debt. This change in capital structure will not affect the market value and the overall risk of the firm. The debt remains virtually risk - free. How will the RE by this change? First we have to calculate the WACC of the company before the change in capital structure. [pic] We know that the change in capital structure will not affect the WACC of the firm, nor the yield on the debt. Thus only RE will be affected. [pic] By repurchasing equity and financing the repurchase through debt, the equity position of the firm decreases, making the equity more risky. This is reflected by the increase in RE from 15.05% to
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