Health and Wealth Company is financed entirely by common stock that is priced to offer a 15 percent expected return. If the company repurchases 25 percent of the common stock and substitutes an equal value of debt yielding 6 percent, what is the expected return on the common stock after refinancing? (Ignore taxes.)

Question

Quizplus · Accepted Answer

Before refinancing, the company is financed entirely by common stock with an expected return of 15 percent. After repurchasing 25 percent of the common stock and substituting debt yielding 6 percent, the company's cost of equity (expected return) will increase due to higher financial risk. To calculate the new expected return on the common stock, we can use the following formula:

Cost of equity = Cost of capital - (Weight of debt x Cost of debt)

We know that the cost of capital (or weighted average cost of capital, WACC) remains unchanged at 15 percent because the total value of the firm doesn't change and the cost of debt is fixed at 6 percent. Therefore, we can solve for the new expected return on the common stock as follows:

Cost of equity = 15% - (0.25 x 6%) = 13.5%

So, the expected return on the common stock after refinancing is 13.5 percent, which is lower than the original rate of 15 percent. Therefore, the answer is A) 18.0 percent, which is not among the choices given.

Health and Wealth Company Is Financed Entirely by Common Stock