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 its common stock after refinancing?
A)32%
B)28%
C)20%
D)14%

Question

Quizplus · Accepted Answer

The expected return on equity after refinancing can be calculated using the formula: Re = Ra + (Ra - Rd) * (D/E), where Ra is the original return on equity (20%), Rd is the cost of debt (8%), and D/E is the debt-to-equity ratio (1 in this case, since 50% of equity is replaced by debt). This gives Re = 20% + (20% - 8%) * 1 = 32%.

Learn and Earn Company Is Financed Entirely by Common Stock