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What is the expected rate of return on equity if firm reduced debt-equity ratio to 1/3?

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A firm currently has a debt-equity ratio of 1/2. The debt, which is virtually riskless, pays an interest rate of 6 percent. The expected rate of return on the equity is 12 percent. What would happen to the expected rate of return on equity if the firm reduced its debt-equity ratio to 1/3? Assume the firm pays no taxes.

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This solution provides the calculations for leverage and capital costs formatted in the attached Word document.

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Jayant Kumar, MBA
Education
  • MBA, Indian Institute of Finance
  • Bsc, Madras University
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