Question

A firm currently has a debt-equity ratio of 1/2. The debt, which is virtually riskless, pays an interest rate of 6.9%. The expected rate of return on the equity is 11%. What would happen to the expected rate of return on equity if the firm reduced its debt-equity ratio to 1/3? Assume the firm pays no taxes. (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)

Answer 1

According to the information given, the wacc of the firm with debt/Equity ratio of 1/2 needs to be calculated

Debt/ Equity = 1 / 2

Therefore, debt / Total assets = 1/3
Equity / total assets = 2/3

cost of debt = 6.9%

cost of equity = 11%

wacc = debt/total assets * cost of debt + Equity/total assets *cost of equity

wacc = 1/3 * 0.069 + 2/3 * 0.11

wacc = 0.023 + 0.0733

wacc = 9.63%

now if debt/equity decreases to 1/3 then,

debt/total assets = 1/4

equity/total assets = 3/4

0.09633 = 1/4 * 0.069 + 3/4 * cost of equity

0.09633 - 0.01725 = 3 / 4 * cost of equity

0.079083 * 4 / 3 = cost of equity

cost of equity = 10.54%

The expected return would decrease from 11% to 10.54%