Question

General Products has an asset beta of 1.4, and a debt to equity ratio of 0.6. Their tax rate is 0.31. If the risk free rate is 0.03, and the expected return on the S&P500 is 0.11, what is the cost of levered equity for General Products?

Answer 1

Levered Beta = Unlevered Beta x (1 + ((1 – Tax Rate) x (Debt/Equity)))

levered beta = 1.4*(1+((1-0.31)*(0.6)))

levered beta = 1.98

As per CAPM

expected return = risk-free rate + beta * (expected return on the market - risk-free rate)

Expected return% = 3 + 1.98 * (11 - 3)

Expected return% = 18.84