Assume a firm is financed with $2,000 debt that has a market beta of 0.1 and $3,000 equity. The risk-free rate is 3%, the equity premium is 5%, and the firm's overall cost of capital is 10%.
-Refer to the information above. What is the expected return on the firm's debt?

Question

Quizplus · Accepted Answer

We can use the CAPM formula to calculate the expected return on the firm's equity:
Equity Beta = Overall Cost of Capital - Risk-Free Rate / Equity Premium
Equity Beta = 10% - 3% / 5%
Equity Beta = 1.4
Expected Return on Equity = Risk-Free Rate + Equity Beta * Equity Premium
Expected Return on Equity = 3% + 1.4 * 5%
Expected Return on Equity = 10%
To calculate the expected return on debt, we can use the formula:
Expected Return on Debt = Risk-Free Rate + Debt Beta * (Overall Cost of Capital - Risk-Free Rate)
Debt Beta = Market Beta of Debt / (1 + (Market Value of Debt / Market Value of Equity))
Debt Beta = 0.1 / (1 + (2,000 / 3,000))
Debt Beta = 0.0571
Expected Return on Debt = 3% + 0.0571 * (10% - 3%)
Expected Return on Debt = 3.5%

Assume a Firm Is Financed with $2,000 Debt That Has