Pay-Day Banks Inc.is a short-term lender.Pay-Day is all equity financed.Pay-Day has 20 million shares outstanding which trade for $7 per share.Pay-Day's shareholders require a return of 9%.
Cash-Mart Financial is also a short-term lender.It's shares are trading for $15 per share.Cash-Mart has 10 million shares outstanding.Cash-Mart's corporate bonds are rated BB and are trading for 87.5% of face value to yield 7%.The face value of Cash-Mart's debt is $100 million.
What is the required return of Cash-Mart's shareholders? (Assume that the tax rate is 0%.)

Question

Quizplus · Accepted Answer

The required return of shareholders in the levered firm is given by M&M Proposition II: k_E = k_U + (k_U - k_D) 11ea7fdb_fc61_e235_a768_85919e3871f6_TB2902_11 Pay-Day is all equity financed, so k_U is equal to the return required by its shareholders: k_U = 9% For Cash-Mart: E = $15 × 10M = $150M D = 0.875 × $100M = $87.5M 11ea7fdb_fc61_e236_a768_715fc311b1bf_TB2902_11 = 11ea7fdb_fc61_e237_a768_414d8e3283e8_TB2902_11 = 0.5833 k_E = 0.09 + (0.09 - 0.07) × 0.5833 = 0.10167 or 10.17%