What is the expected return on equity for a tax-free firm with a 15 percent expected return on assets that pays 12 percent on its debt,which totals 25 percent of assets?

Question

Quizplus · Accepted Answer

The formula for calculating the expected return on equity is:
Expected Return on Equity = Expected Return on Assets - (Debt/Equity) x (Expected Return on Assets - Interest Rate on Debt)

Given:
Expected Return on Assets = 15 percent
Interest Rate on Debt = 12 percent
Debt/Assets = 0.25

Substituting the values in the formula:
Expected Return on Equity = 15% - (0.25/0.75) x (15%-12%) = 16%

What Is the Expected Return on Equity for a Tax-Free