Holland Auto Parts is considering a merger with Workman Car Parts.Workman's market-determined beta is 0.9,and the firm currently is financed with 20% debt,at an interest rate of 8%,and its tax rate is 25%.If Holland acquires Workman,it will increase the debt to 60%,at an interest rate of 9%,and the tax rate will increase to 35%.The risk-free rate is 6% and the market risk premium is 4%.What will Workman's required rate of return on equity be after it is acquired?
A) 7.4%
B) 8.9%
C) 9.3%
D) 9.6%
E) 9.7%

Question

Quizplus · Accepted Answer

The correct answer is E.The required rate of return on equity for Workman after it is acquired can be calculated using the following formula:$$r_e = r_f + \beta * (r_m - r_f) + (1 - t) * D/E * (r_d - r_f)$$where:* $$r_e$$ is the required rate of return on equity* $$r_f$$ is the risk-free rate* $$\beta$$ is the market-determined beta* $$r_m$$ is the market risk premium* $$t$$ is the tax rate* $$D/E$$ is the debt-to-equity ratio* $$r_d$$ is the interest rate on debtPlugging in the given values, we get:$$r_e = 6% + 0.9 * (4%) + (1 - 0.35) * 0.6 * (9% - 6%) = 9.7%$$

Holland Auto Parts Is Considering a Merger with Workman Car