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You are starting a company and need £1,000 to buy capital. You can take the funds...

You are starting a company and need £1,000 to buy capital. You can take the funds from your savings, in which case the firm is 100% equity financed. Alternatively, you can use £200 of your own money and borrow the remainder. If you borrow, the interest rate on the loan will be 5%. In good years, the company will earn £100 and in bad years it will earn £50. Good and bad years occur with equal frequency. After you make the interest payment on the loan (if any), you receive the remainder in profits as the firm’s owner. Compute the expected return on equity and the standard deviation of the return on equity. Which financing option will you select?

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Expert Solution

Option with 80% leverage i.e. $800 debt and $200 equity is better, since its expected return is better than 100% equity option, and in case of any bad situation its not going to be below 5% that is lowest return in both options.

jeff jeffy answered 1 year ago
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