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