Question

Health and Wealth Company is financed entirely by common stock that is priced to offer a 18% expected return. If the company repurchases 30% of the common stock and substitutes an equal value of debt yielding 8%, what is the expected return on the common stock after refinancing?

Answer 1

Answer:

The expected return is 22.29%

Explanation:

The computation of the expected return on the common stock after refinancing is shown below:

= Expected return + (Debt ÷ Equity) × (Expected return - debt yield)

= 18% + (0.30 ÷ 0.70) × (18% - 8%)

= 18% + (0.30 ÷ 0.70) × 10%

= 22.29%

Hence, the expected return is 22.29%

We simply applied the above formula