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    Rate of return on equity

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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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    Solution Preview

    We first find the WACC for the firm
    WACC = Proportion of debt X cost of debt + Proportion of equity X cost of equity
    We are given
    D/E = 0.5
    This implies that D=0.5E
    We need D/(D+E) which is the proportion of debt and ...

    Solution Summary

    This solution explains the impact on the rate of return on equity of a change in the debt equity ratio.