"Hubbard Industries is an all-equity firm whose shares have an expected return of 9.1%. Hubbard does a leveraged recapitalization, issuing debt and repurchasing stock, until its debt-equity ratio is 0.45. Due to the increased risk, shareholders now expect a return of 12.5%. Assuming there are no taxes and Hubbard's debt is risk-free, what is the interest rate on the debt?"

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Parrain Parrain · Answer 1 · 2020-05-10T04:52:24+02:00

Answer: 1.54 %

Explanation:

Assuming no risk, the interest rate on the debt can be calculated using the Cost of Equity of levered Capital formula which is,

Cost of Equity of Levered Capital = Un levered cost of capital + Debt / equity * (rate of return - rate of debt)

All the variables are present except the rate of debt.

Plugging them in is,

0.125 = 0.091 + 0.45 ( 0.091 - rD)

0.125 = 0.091 + 0.04095 - 0.45(rD)

0.125 = 0.13195 - 0.45rD

0.45rD= 0.13195 - 0.125

0.45rD = 0.00695

rD = 0.00695/0.45

rD = 0.01544444444

rD = 1.54%

1.54% is the interest rate on the debt.