Train Company is currently financed by 30% debt and 70% equity. The firm's cost of equity is currently 18%. It will issue debt and repurchase equity such that it has equal amounts of debt and equity in its capital structure. The risk-free rate is 5% and the market is expected to return 15% next year. The firm faces a tax rate of 25% and can borrow at the risk-free rate.

A) What is the unlevered beta of the firm?

B) What the will the cost of equity be after the transaction?

C) Sheldon is an investor whose portfolio is expected to return 12% next year. This portfolio contains Train Company stock and the risk-free asset.

i) What is Sheldon's current holding of Train Company and of the risk-free asset?

ii) What must Sheldon do to main the same level of risk in his portfolio after the transaction?

What would the allocation be between Train Company stock and the risk-free asset?

Answer rating: 100% (QA)

SOLUTION A The unlevered beta of the firm can be calculated using the following formula Unlevered Beta Levered Beta 1 1Tax Rate Debt Equity Unlevered ... View the full answer