Question

Company X and Company Y have the same cost of capital and identical asset portfolios with a market value of 1000. Company X has zero debt. The expected return on equity for Company X is 15%. The firm value of Company Y is made up of 50% debt and 50% equity. The expected return on debt for Company Y is 9%. Assuming perfect capital market, what is the expected return on equity for Company Y

Answer 1

The expected return on equity for Company Y is:

= 0.21 or 21%

Step-by-step explanation:

a) Data and Calculations:

Company X Company Y

Market value of assets 1,000 1,000

Equity 1,000 500

Debt 0 500

Expected return on equity 15%

Expected return on debt 9%

Return on Company X = 150 (1,000 * 15%)

Return on Company Y debt = 500 * 9% = 45

Return on Company Y equity = (150 - 45)/500 = 0.21

b) Under perfect capital market conditions, the total return for Company Y will be equal to 150 as in Company X. The rate of return will then be determined after subtracting the interest on debt (500 * 9%). This will leave 105 as the return for equity. This amount is then divided by the value of equity to derive the rate of return.