Time $1$ Payoff Time $0$ Value Leverage Expected Returns

Good Economy Bad Economy Average

Face Value of Debt $($FV$)$ Assets $($A$)$ Debt $($D$)$ Equity $($E$)$ A D E A D E A D E Debt over Assets A $($WACC$)$ D E Notes

$014000140090009001150011501000010000\%15\%$ n$/$a $15\%$

$100$

$200$

$210$

$300$

$400$

$500$

$52514005258759005253751150525625100050050050\%15\%5\%25\%$ See Slide $17$ Module $301$

$600$

$700$

$800$

$900$

$1000$

$1100$

$1200$

$1300$

$1400$

Instructions: Fill out the missing cells $($shaded in grey$)$ and then plot the expected return on equity, debt and WACC $($columns O to Q$)$ against the fraction you finance yourself with debt, i$.$e$.,$ D$/($A$),$ i$.$e$.$ Column N

Hints:

a$)$ The value of total firm assets $($A$)$ is just a portfolio of DEBT $($D$)$ and EQUITY $($E$)$

b$)$ Value Equity is a call option on the asset with strike price equal to the face value of debt

c$)$ Recall equity holders are protected by limited liability $($minimum value $=0)$

d$)$ Use scatter plot with smooth lines to draw the graph.