Company XYZ is currently financed with 40% debt (a 40% debt-to-value ratio). The average current yield on
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Company XYZ is currently financed with 40% debt (a 40% debt-to-value ratio). The average current yield on government securities is 10%. The expected return on the SP500 portfolio is 20%. The corporate tax rate is 20%, and XYZ’s stock has a beta of 1.6. XYZ can borrow at 200 basis points (2%) above the prevailing government rate.
(a) What is XYZ’s weighted average cost of capital under the current capital structure?
(b) What is XYZ’s cost of capital if it decides to pursue a policy of always using 100% equity financing instead?
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