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BUAD 306 Fall 2007 Problem Set3solutions

# BUAD 306 Fall 2007 Problem Set3solutions - \$1,500,000 worth...

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BUAD 306 Problem Set # 3 Equations: Ra = Rf + Ba(Rm-Rf) Re=Ra + (Ra-Rd)(D/E) Re = Ru + (Ru-Rd)(D/E)(1-T) 1. If the beta of an asset is .8, the expected return on the market is 10% and the riskfree rate is 4%, what is the expected return on the asset? Ra = Rf + Ba(Rm-Rf) = .04 +.8(.10-.04) = .04 + .8(.06) = .088 2. a. If the return on an asset is 12%, the return on debt is 6%, and the firm has \$3,000,000 worth of debt and \$3,000,000 worth of equity, what is the return on equity for the firm? Re = Ra + (Ra-Rd)(D/E) = .12 + (.12-.06)(3,000,000/3,000,000) = .18 2b. If the firm above issues \$3,000,000 more in debt and leaves equity the same, what is the new cost of equity? Re = Ra + (Ra-Rd)(D/E) = .12 +(.12-.06)(2/1) = .24 An increase in debt causes the risk of the stock to rise, shareholders require a higher return. 2c. If the firm above in 2a buys back stock so it has \$3,000,000 worth of debt and

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Unformatted text preview: \$1,500,000 worth of equity, what is the new cost of equity? Re = Ra + (Ra-Rd)(D/E) = .12 + (.12-.06)(2/1) = .24 A stock buyback increases leverage similar to increasing debt levels. This causes the stock return to rise because of the increase in risk. 2d. If the firm in 2a above issues more stock so that it’s debt equity ratio is .5, what is the new cost of equity for the firm? Re = Ra + (Ra-Rd)(D/E) = .12 + (.12-.06)(.5) = .15 An increase in financing thru stock has less risk than paying off bondholders first. The final result is that the cost of equity is lower than the original case. 3. What is the cost of equity for a firm if the unlevered return (no debt) is 7%, the cost of debt is 5%, the debt equity ratio is 1 and the tax rate is 30 percent? Re = Ru + (Ru-Rd)(D/E)(1-T) = .07 + (.07-.05)(1)(1-.30) = .07 + .02(.7) = .084...
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