Question

"Hubbard Industries is an​ all-equity firm whose shares have an expected return of 9.1%. Hubbard does a leveraged​ recapitalization, issuing debt and repurchasing​ stock, until its​ debt-equity ratio is 0.45. Due to the increased​ risk, shareholders now expect a return of 12.5%. Assuming there are no taxes and​ Hubbard's debt is​ risk-free, what is the interest rate on the​ debt?"

Answer 1

Answer: 1.54 %

Explanation:

Assuming no risk, the interest rate on the debt can be calculated using the Cost of Equity of levered Capital formula which is,

Cost of Equity of Levered Capital = Un levered cost of capital + Debt / equity * (rate of return - rate of debt)

All the variables are present except the rate of debt.

Plugging them in is,

0.125 = 0.091 + 0.45 ( 0.091 - rD)

0.125 = 0.091 + 0.04095 - 0.45(rD)

0.125 = 0.13195 - 0.45rD

0.45rD= 0.13195 - 0.125

0.45rD = 0.00695

rD = 0.00695/0.45

rD = 0.01544444444

rD = 1.54%

1.54% is the interest rate on the​ debt.