Consider a simple firm that has the following market-value balance sheet:

Next year, there are two possible values for its assets, each equally likely: $1200 and $960. Its debt will be due with 5% interest. Because all of the cash flows from the assets must go to either the debt or the equity, if you hold a portfolio of the debt and equity in the same proportions as the firm's capital structure, your portfolio should earn exactly the expected return on the firm's assets. Show that a portfolio invested 40% in the firm's debt and 60% in its equity will have the same expected return as the assets of the firm. That is, show that the firm's pre-tax WACC is the same as the expected return on itsassets.

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Liabilities and Equity Debt Equity Assets 400 600