A new business requires a $20,000 investment today,and will generate a one-time cash flow of $25,000 after one year.The business will be financed with 20% equity and 80% debt.If the firm can borrow at 4%,what is the return on levered equity?

Question

Quizplus · Accepted Answer

The cost of debt is 80% x 4% = 3.2%. 
The cost of equity can be solved using the formula: 
return on levered equity = return on unlevered equity + (return on unlevered equity - cost of debt) x (debt/equity) 
Assuming the unlevered cost of equity is 20% (1/5), 
return on levered equity = 20% + (20% - 3.2%) x (4/1) = 108.8% 
Rounding to the nearest whole percent gives us the answer of 109%.

A New Business Requires a $20,000 Investment Today,and Will Generate