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Q1. Firm XYZ is currently financed entirely with equity. The market value of the firm's assets...

Q1. Firm XYZ is currently financed entirely with equity. The market value of the firm's assets and equity is ?? = ?? = 500, and the expected return on the firm's assets and equity is ?? = ?? = 12.5 percent. Suppose the firm issues debt with a value of ? = 200, and uses the proceeds to retire equity. The market value of the firm remains the same, ?? = ?? + ? = 500. If the expected return on the debt is ?? = 7 percent, what is the expected return on the firm's levered equity?

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Answer #1

Debt Equity ratio = 200/ (500-200) = 2/3

expected return on the firm's levered equity = Ru + (D/E) * (Ru-Rd)

= 12.5%+ (2/3)*(12.5%- 7%)

=16.17%

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