Question

You have the following data on The Home Depot, Inc.

Market value of long-term debt: $20,888 million

Market value of common stock: $171,138 million

Beta: 1.04

Yield to maturity on debt with 10 years to maturity: 2.167%

Expected return on equity: 8.108%

Marginal tax rate: 35%

Assume that if Home Depot issues new bonds, the bonds will have 10 years to maturity.

Suppose that managers at Home Depot decide to increase the proportion of debt to 20% of the value of the company.

The managers estimate that yield on the company’s 10 year bonds will rise to 2.361% if the company changes its capital structure in this manner.

What would be the expected rate of return on equity under the new capital structure?

Answer 1

Given,

Market value of long-term debt: $20,888 million

Market value of common stock: $171,138 million

Beta: 1.04

Yield to maturity on debt with 10 years to maturity: 2.167%

Expected return on equity: 8.108%

Marginal tax rate: 35%171138+20888

Solution,

Current value of the company=value of equity + value of debt

=171138+20888

=$ 192026

value of new debt= value of the company* % of new debt

=192026*20%

=$ 38405.20

Particulers	Calculation	Amount
Net Earnings	171138*8.108%	13875.869
Add Tax @ 35%	(13875.869*100/65)-13875.869	7471.62
Earnings Before tax	13875.869+7471.62	21347.49
Add Interest ob bond	20888*2.167%	452.64
Earnings before interest and tax	21347.49+452.64	21800.13

New equity capital structure= Old capital structure- new debt

=192026-38405.20

=$153620.80

New Equity =$153620.80

New Debt= $ 38405.20

Particulers	Calculation	Amounr
Earnings Before Interst & Tax		21800.13
Less Interest	38405.20*2.361	906.75
Earnings after interest	21800.13-906.75	20893.38
Less Tax @35%	20893.38*35%	7312.68
Earnings after interest and Tax	20893.38-7312.68	13580.7

Expected return on Equity= Earnings / Value of equity

=13580.7/153620.80

=0.008840

=8.84%

expected rate of return on equity under the new capital structure is 8.84%