Learn and Earn Company is financed entirely by Common stock that is priced to offer a
20% expected return. If the company repurchases 50% of the stock and substitutes an equal value of debt yielding 8%, what is the expected return on the common stock after refinancing?
A) 32%
B) 28%
C) 20%
D) None of the above

Question

Quizplus · Accepted Answer

The expected return on the common stock after refinancing can be calculated using the formula for the levered cost of equity: Re = Ra + (Ra - Rd) * (D/E). Here, Ra = 20%, Rd = 8%, and D/E = 1 (since 50% debt and 50% equity). Thus, Re = 20% + (20% - 8%) * 1 = 32%.

Learn and Earn Company Is Financed Entirely by Common Stock