Question

Suppose Uber has only one project with a cash flow of $40,000 and an unlevered cost of

equity of 10%. If the company borrows $20,000 at 5% to make the investment, what is

expected return to equity holders?

The answer is 16.11%, but I am not sure how my prof got that answer.

Answer 1

Given cash flow = $40,000

Unlevered cost of equity = 10%

Amount borrowed = $20,000

Initial equity cost = [40,000/ (1+ 0.10) ]– amount borrowed = [40,000/1.1] – 20,000 = $16,363.6363

Amount to be repaid = amount borrowed * (1+ borrowing rate) = 20,000 *(1+ 0.05) = 20,000 * 1.05 = $21,000

Now, the cash flow of equity after repayment = initial cash flow – amount repaid = 40,000 – 21,000 = $19,000

Expected return on equity = [Cash flow of equity after repayment / initial equity cost] -1

= [19,000/ 16,363.6363] -1 = 1.161111 -1 = 0.161111

= 16.11%

Expected return on equity = 16.11%