Question

Health and Wealth Company is financed entirely by common stock that is priced to offer a 12 percent expected return. If the company repurchases 20 percent of the common stock and substitutes an equal value of debt yielding 8 percent, what is the expected return on the common stock after refinancing

Answer 1

Answer: 13%

Step-by-step explanation:

By substituting 20% of debt for debt yielding 8%, the company now has 20% financing from debt and 80% from equity.

The expected return on common stock after refinancing can be calculated by;

Return after refinancing = Return before refinancing +
`(Debt)/(Equity)`(return before refinancing - Debt yield)

= 12% +
`(0.2)/(0.8) (0.12 - 0.08)`

= 13%