Question

Use next​ year's Cash Flow Forecast for Blank Company to answer the​ question(s) below.

Demand	Cash Flow
Weak	​$25,000
Expected	​$35,000
Strong	​$45,000

Suppose Blank Company has only one​ project, as forecast​ above, and an unlevered cost of equity of​ 8%. If the company borrows​ $10,000 at​ 5% to make the​ investment, what is expected return to equity​ holders? Assume the demand is as expected.

Answer 1

ANS: Expected Demand (Cash Flow) = $ 35000

Equity Cost = [ ($ 35000 / 1.08) - $ 10000] [ (Expected Cash Flow / 1+ Ke) - Debt Amount ]

= $ 22407.40

Payment to Debt-holders = $ 10000 (1+.05) Borrowed Amount ( 1 + rate/100)

= $ 10500

So, the Cash Flow to equity = Expected Cash Flow - Payment made to Debt-holder

= $ 35000 - $ 10500

= $ 24500

Therefore, Expected Return to Equity holder = [ (Cash flow to Equity / Equity Cost)  - 1 ] * 100

=[ ($ 24500 / $ 22407.40) - 1 ] * 100

= 9.338%