Hubbard’s Pet Foods is financed 50% by common stock and 50% by bonds. The expected return

Hubbard’s Pet Foods is financed 50% by common stock and 50% by bonds. The expected return on the common stock is 12.1%, and the rate of interest on the bonds is 6.7%. Assume that the bonds are default-free and that there are no taxes. Now assume that Hubbard’s issues more debt and uses the proceeds to retire equity. The new financing mix is 40% equity and 60% debt.

a.	If the debt is still default-free, calculate the expected rate of return on equity? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Expected rate of return

%

b.	Calculate the expected return on the package of common stock and bonds? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Expected rate of return

%

Explanation:

a.&b.

rassets = (0.50 × 12.1%) + (0.50 × 6.7%) = 9.40%

After the refinancing, the package of debt and equity must still provide an expected return of 9.40%, so that:

9.40% = (0.40 × requity) + (0.60 × 6.7%) requity = (9.40% − 4.020%)/0.40 = 13.45%

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. Round your answer to 2 decimal places.)

Expected rate of return equity

%

Explanation:

Some values below may show as rounded for display purposes, though unrounded numbers should be used for the actual calculations.

The ratio of debt to firm value is:	D	=	1	=	1
	D + E		1 + 2		3

rassets = (1/3 × 6.9%) + (2/3 × 11%) = 9.63%

If the firm reduces its debt-equity ratio to 1/3, then: