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.
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a.
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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.)
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Expected rate of
return
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%
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b.
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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
|
%
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Explanation:
a.&b.
rassets
= (0.50 × 12.1%) + (0.50 × 6.7%) = 9.40%
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After
the refinancing, the package of debt and equity must still provide an
expected return of 9.40%, so that:
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9.40% = (0.40 × requity)
+ (0.60 × 6.7%) requity = (9.40% − 4.020%)/0.40 =
13.45%
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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.
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The ratio of debt to firm value
is:
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D
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=
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1
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=
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1
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D + E
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1
+ 2
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3
|
rassets
= (1/3 × 6.9%) + (2/3 × 11%) = 9.63%
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If the firm reduces its
debt-equity ratio to 1/3, then:
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