points 3 Leverage Part I You are told that a company is fina

points 3. Leverage, Part I You are told that a company is financed half with debt and half with equity. Using that information, complete the following table [10 points):

Solution

Based on CAPM relation,

Expected rate of return on security = Risk free rate + Beta *(Expected market return - Risk free rate)

Now, for equity,

Expected return on equity (r_E) = 10% + 1.5 * (18% - 10%) = 10% + 1.5 * 8% = 22%

Now, for debt,

Expected return on debt (r_D) = 10% + Beta_D * (18% - 10%) => 12% = 10% + Beta_D * 8%

=> 2% = Beta_D * 8%

=> Beta_D = 0.25

For a portfolio with equal debt and equal equity expected return and beta should be weighted average.

Beta of Portfolio, Beta_A = (1.5 * 50%) + (0.25 * 50%) = 0.875

Return on Portfolio, R_A = (22% * 50%) + (12% * 50%) = 17%