Additional Exercise (2) You are hired as a CFO of the company ABC. ABC has just been through an IPO process. The CEO is about to undertake a new investment project and know that one source of...

In question C there is a plot of of cost of debt, cost of equity and cost of capital. Can you show how r_a is calculated to be 0.18667?

r_d = Cost of debt

r_a = cost of capital

r_e = Cost of equity

Extracted text: Additional Exercise (2) You are hired as a CFO of the company ABC. ABC has just been through an IPO process. The CEO is about to undertake a new investment project and know that one source of shareholder value is the unlevered cash flow. a) Explain the CEO another source of shareholder value when undertaking a new investment project (Don't worry if you can't answer it now, we will cover on this more in lecture 10) Answer: See exhibit 13.2 at page 435. Back to the project ABC consider undertaking. From the market analysis team you get the following infor- mation: Value of the initial levered equity is 800 Value of the levered equity in the positive scenario is 1550 and 550 in the negative scenario Value of debt in the project today is 400 with an interest rate of 6% Probability of the positive scenario is 45% You can assume perfect capital markets. Now it's your turn to calculate. b) What is the expected return on the debt and levered equity? Answer: We know that the firm won't go bankrupt since the value of the equity in both scenarios is larger than zero. Hence, the expected return on the debt is the interest rate of 6%. The expected return of the equity is (1.550 800 (550 * 45% + 800 -1). + 55% = 25% c) Plot the cost of debt, cost of equity and unlevered cost of capital as a function of the D/V ratio Answer: V D E D/E D/V r d ra 0.186667 0.186667 re 1200 1200 6% 1200 200 1000 0.2 0.166667 6% 0.186667 0.212 1200 400 800 0.5 0.333333 6% 0.186667 0.25 1200 600 600 0.5 6% 0.186667 0.313333