Question

Assume perfect capital markets. Mezzanine Corp., of which you are the CFO, is currently financed 60% by equity and 40% by debt. Your expected free cash flow is $15 million per year and is expected to grow at a 5% annual rate forever. You estimate (based on your asset beta) that your assets should return approximately 15%. Your debt is risk-free and pays 7.5%. Ignore taxes. What is the expected return on equity of Mezzanine Corp.

Answer 1

return on equity 20%

Step-by-step explanation:

The return on asset will be like the WACC of the company

thus, we have:

`WACC = K_e((E)/(E+D)) + K_d(1-t)((D)/(E+D))`

with:

Ke x

Equity weight 0.6000

Kd 0.075

Debt Weight 0.4000

t 0 (ignore taxes)

with WACC = 0.15

`0.15 = K_e(0.6) + 0.075(1-0)(0.4)`

`K_e(0.6) = 0.15 - 0.075(1-0)(0.4)`

`K_e = ( 0.15 - 0.075(1-0)(0.4) ) / 0.6`

Ke = 20%