Question

7. GH Company has $5000 of debt and $20,000 of equity. GH pays 5% interest on all of its debt. GH has an equity beta of 2. The market risk premium is 5.5% and the risk free rate of return is 2%. WJK has a 30% marginal tax rate.a. What is WJK’s Unlevered Beta?b. How much of the expected rate of return on equity is due to asset risk?c. How much of the expected rate of return on equity is due to financial leverage?

Answer 1

Answer:

WJK's Unlevered Beta = 1.7

 Expected rate of return = 13%

Financial leverage = 0.25

Explanation:

given data

debt = $5000

equity = $20,000

interest = 5%

equity beta  = 2

market risk premium = 5.5%

risk free rate of return = 2%

marginal tax rate = 30%

solution

we find here Unlevered Beta that is

Unlevered Beta = $\frac{Beta (Levered)}{{1 + [ (1- tax rate)* (\frac{Debt}{Equity})]}}$    ...........................1

as that we can say  

WJK's Unlevered Beta = $\frac{Beta of GH (Levered)}{{1 + [ (1- tax rate)* (\frac{Debt of GH}{Equity of GH})]}}$

put here value we get

WJK's Unlevered Beta = $\frac{2}{{1 + [ (1- 0.3)* (\frac{5000}{20000})]}}$

WJK's Unlevered Beta = $\frac{2}{1.18}$

WJK's Unlevered Beta = 1.7

and

Expected rate of return on equity of GH using CAPM = Risk free rate + Beta of GH ×  (Market risk premium)

Expected rate of return =  2% + 2 × (5.5%)

 Expected rate of return = 13%

and

Financial leverage will be here

Financial leverage = $\frac{Debt}{Equity }$

Financial leverage = $\frac{5000}{20000 }$

Financial leverage = 0.25