Suppose Blank Company has only one project, as forecast above, and an unlevered cost of equity of 8%. If the company borrows $10 000 at 5% to make the investment, what is the return to equity holders if demand is strong?
A)38.0%
B)54.0%
C)28.6%
D)8.0%

Question

Quizplus · Accepted Answer

We need to calculate the levered cost of equity first before we can calculate the return to equity holders. Using the formula:
Levered Cost of Equity = Unlevered Cost of Equity + (Debt/Equity) * (Unlevered Cost of Equity - Interest Rate)
Levered Cost of Equity = 8% + (10 000/10 000) * (8% - 5%)
Levered Cost of Equity = 11%
Now using the formula for return to equity holders:
Return to Equity Holders = Revenue - Expenses - Interest - Principal Repayment / Equity
For strong demand, revenue is $42 000 and expenses are $20 000 (from the table).
Interest expense is $500 (5% of $10 000) and principal repayment is $10 000.
Return to Equity Holders = $42 000 - $20 000 - $500 - $10 000 / $30 000
Return to Equity Holders = 54.0% (rounded to one decimal place)

Suppose Blank Company Has Only One Project, as Forecast Above