Problem 16-11 Leverage and the Cost of Capital (LO1) Astromet is financed entire
ID: 2783873 • Letter: P
Question
Problem 16-11 Leverage and the Cost of Capital (LO1) Astromet is financed entirely by common stock and has a beta of 1.40. The firm pays no taxes. The stock has a price-earnings multiple of 13.0 and is priced to offer an expected return of 10.7%. The company decides to repurchase half the common stock and substitute an equal value of debt. Assume that the debt yields a risk-free 5.0%. Calculate the following a. The beta of the common stock after the refinancing (Round your answer to 1 decimal place.) Beta of the common stock 2.8 b. The required return and risk premium on the common stock before the refinancing (Enter your answer as a percent rounded to 1 decimal place.) Required return Risk premium 10.71% 5.71 %Explanation / Answer
a) Currently, beta(equity) = beta(asset) = 1.4
With leverage, beta(asset) = beta(equity) x weight(equity) + beta(debt) x weight(debt)
=> 1.4 = beta(equity) x 50% + 0 x 50%
=> beta(equity) = 2.8
b) Required return = 10.7
Risk Premium = 10.7 - 5 = 5.7%
c) Required return = r(asset) + D/E x (r(assets) - r(debt)) = 10.7% + 1 x (10.7% - 5%) = 16.4%
Risk Premium = 16.4% - 5% = 11.4%
d) Required return on debt = risk-free rate = 5%
e) Required return on the company remains the same = 10.7% = (50% x 16.4% + 50% x 5%)