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Morrison Medical Inc., an all-equity firm, has earnings before interest and taxes of $950,000, an un-levered beta of .80 and a tax rate = 35%. In the market, you observe that Government T-bills are being sold to yield 2% and the S&P/TSX Composite Index is expected to yield 9%. Assume a world with taxes and a cost for the risk of default. All general M&M assumptions apply. You have also been provided the following information:

Value of Debt	Cost of Debt (Rd)	Beta	PV of Financial Distress Costs
$0	-	0.80	0
$5,000,000	5.5%	?	$800,000
$7,000,000	7.0%	2	?

1. What is the market value of the firm and the market value of the equity if they issue $5,000,000 in debt with a coupon rate of 5.5% and use the proceeds to repurchase shares? (4 marks)
2. What is the new cost of equity? (2 marks)
3. According to CAPM, what is the new beta? (1 mark)
4. Why is the beta calculated in problem 3(d) different than the betas you calculated in problems 1(f) and 2 (d)? (1 mark)
5. What is the market value of the firm if the firm issues $7,000,000 in debt? (5 marks)
6. What would be the PV of financial distress costs if the firm issues $7,000,000 in debt? (2 marks)

What is the optimal level of debt $0, $5,000,000 or $7,000,000? Explain.

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