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 expected return to equity holders?
A)11.6%
B)8.0%
C)9.33%
D)30.0%

Question

Quizplus · Accepted Answer

The expected return to equity holders can be calculated using the following formula:

Expected return on equity = Unlevered cost of equity + (Debt / Equity) * (Cost of Debt − Unlevered cost of equity)

Here, the unlevered cost of equity is given as 8%. The company borrows $10 000 at 5% to make the investment, so the Debt/Equity ratio is 10 000/0 = infinity.

Therefore, the expected return on equity = 8% + (10 000/0) * (5% - 8%) = 8% - infinity, which is not a valid calculation.

However, the Debt/Equity ratio of infinity indicates that the company is using all debt financing and has no equity. This means that the expected return on equity is not applicable in this scenario, and hence, option C, which gives a value for the expected return on equity, is not a valid answer.

The correct answer is B, 8%, which is the unlevered cost of equity and represents the expected return to the equity holders in the absence of any debt financing.

Suppose Blank Company Has Only One Project, as Forecast Above