Question

Demand	Cash Flow
Weak	$25,000
Expected	$35,000
Strong	$45,000

Suppose Blank Company has only one project, with the forecasted cash flows shown in the table above, and an unlevered cost of equity of 9%. If the company borrows $10,000 at 5% to make the investment, what is the return to equity holders if demand is weak?

Answer 1

Since the expected Cash Flow is $35,000 we can assume that the total investmnet by Blank company is $35,000.

So, Total Investment = $35,000.

In this total investment

              Debt = $10,000

              Hence, Equity = $35,000-$10,000 = $25,000

% Debt = $10,000/$35,000 = 28.57%

% Equity = $25,000/$35,000 = 71.43%

Cost of Debt = 5%

Cost of Equity = 9%

So, minimum overall required rate of return = 28.57% * 5% + 71.43% * 9% = 0.0143 + 0.0643 = 0.0786

Thus the investment must earn = 0.0786 * $35,000 = $2,751 per year.

Annual Interest Expense = 0.05 * $10,000 = $500

Hence,

           Annual Return on Equity = $2,751- $500 = $2,251.

          Annual % Return on Equity = $2,251 / $25,000 = 9%.