Question

KP Company has a unlevered beta of 1.0. KP is financed with 50% debt and has a levered beta of 1.7. If the risk free rate is 6.5% and the market risk premium is 8%, how much additional premium that KP’s stockholders require to be compensated for financial risk? Select one: a. 4.8% b. 5.2% c. 5.6% d. 6.1% e. 6.7%

Answer 1

The required return if the company has no debt:

= Risk free rate + Unlevered beta*Market risk premium

= 6.5% + 1.0*8%

= 6.5% + 8%

= 14.50%

The required return if the company has debt:

= Risk free rate + Levered beta*Market risk premium

= 6.5% + 1.7*8%

= 6.5% + 13.6%

= 20.1%

Therefore, the extra premium required for financial risk is:

= 20.1% - 14.50%

= 5.60%.

Hence, the answer is option c.

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