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Health and Wealth Company is financed entirely by common stock that is priced to offer a 12 percent expected return. If the company repurchases 20 percent of the common stock and substitutes an equal value of debt yielding 8 percent, what is the expected return on the common stock after refinancing

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Answer: 13%

Explanation:

By substituting 20% of debt for debt yielding 8%, the company now has 20% financing from debt and 80% from equity.

The expected return on common stock after refinancing can be calculated by;

Return after refinancing = Return before refinancing + [tex]\frac{Debt}{Equity}[/tex](return before refinancing - Debt yield)

= 12% + [tex]\frac{0.2}{0.8} (0.12 - 0.08)[/tex]

= 13%

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