Lake Inc is an all equity financed firm operating in Florida. The firm has 1,000,000 shares outstanding trading for $25 per share. Additionally, the firm plans to pay all its future earnings as cash dividends to its shareholders.

The current return on Government of US T-Bills is 2%, the return on the market portfolio is 10% and Lake's estimated beta is 1.20.

Part 1: Consider a world with no taxes and no bankruptcy costs:

a. What is the market value of Lake Inc? (remember 3 decimal places).

b. According to CAPM, what is the cost of equity for Lake Inc?

c. What is the WACC for Lake Inc?

d. Lake Inc is considering borrowing $1,000,000 at 5% and using the proceeds to repurchase some shares. Briefly explain in words using the numbers as part of your description, the impact this will have on the market value of the firm and on the WACC.

Part 2: Consider a world with taxes but no bankruptcy costs. The tax rate is 40%. Assume the market value of the equity is the same as you calculated in part (a) above.

e. What would be the market value of LakeInc if it plans to add $1,000,000 of debt with a coupon rate of 5% to its capital structure? Debt will be sold at par value and will be used to repurchase shares. The tax rate is 40%.

f. What would be the cost of equity of Lake Inc. if it plans to add $1,000,000 of debt with a coupon rate of 5% to its capital structure? Debt will be sold at par value and will be used to repurchase shares.

g. What would be the WACC of Lake Inc. if it plans to add $1,000,000 of debt with a coupon rate of 5% to its capital structure? Debt will be sold at par value.

h. Now what is the optimal capital structure for Lake Inc? Explain in words and state why.