A firm has a debt/equity ratio of ½.The debt pays a 6% rate of interest.The expected rate of return on equity is 12%.What would happen to the expected rate of return if the firm reduced its debt/equity ratio to 1/3?

Question

Quizplus · Accepted Answer

Reducing the debt/equity ratio from 1/2 to 1/3 decreases the leverage. With less debt relative to equity, the firm pays less interest, which can increase the return on equity if the cost of debt is less than the return on equity. However, because leverage amplifies returns, reducing leverage from a higher to a lower level when the cost of debt (6%) is less than the return on equity (12%) actually decreases the amplification effect, leading to a lower overall expected return. The correct calculation, however, shows an increase in this specific scenario due to the specific numbers given, indicating a misunderstanding in the explanation process. The correct answer, based on the calculation method for the expected rate of return considering the change in leverage, would typically show a nuanced effect of leverage on returns, but in this case, it's stated to increase, which contradicts the typical leverage effect under these conditions.

A Firm Has a Debt/equity Ratio of ½