Assume a firm is financed with 50% safe debt at a cost of 5%, and 50% equity. The firm has a market value of $20 billion and promises a 12% ($2.4 billion)return. In a world with no taxes,
What is the firm's price/earnings ratio? Round your answer to the nearest hundredth.

Question

Quizplus · Accepted Answer

The firm's earnings can be calculated by subtracting the cost of debt from the total return. The cost of debt is 5% of 50% of $20 billion = $0.5 billion. Therefore, the earnings are $2.4 billion - $0.5 billion = $1.9 billion. The market value of the firm is $20 billion, so the price/earnings ratio is $20 billion / $1.9 billion = 10.526, which rounds to 10.53.

Assume a Firm Is Financed with 50% Safe Debt at a Cost