Learn and Earn Company is financed entirely by common stock that is priced to offer a 20 percent expected return. If the company repurchases 50 percent of the stock and substitutes an equal value of debt yielding 8 percent, what is the expected return on its common stock after refinancing?
A)32 percent
B)28 percent
C)20 percent
D)14 percent

Question

Quizplus · Accepted Answer

The expected return on common stock after refinancing increases due to the leverage effect. Initially, the entire company is financed by equity with a 20% expected return. After repurchasing 50% of the stock and substituting it with debt at 8%, the cost of debt is lower than the cost of equity, which increases the return on the remaining equity. This can be calculated using the Modigliani-Miller proposition with taxes ignored. The new expected return on equity can be found using the formula: $E(R_{equity}) = E(R_{assets}) + (D/E) \times (E(R_{assets}) - R_{debt})$, where $D/E$ is the debt-to-equity ratio after refinancing. Since the company substitutes 50% of equity with debt, $D/E = 1$, and $E(R_{assets}) = 20\%$, $R_{debt} = 8\%$. Substituting these values gives $E(R_{equity}) = 20\% + (1) \times (20\% - 8\%) = 32\%$.

Learn and Earn Company Is Financed Entirely by Common Stock