In: Finance
5. Comparing equity financing with debt financing. Consider two
$60,000 investments – call
them Investment A and Investment B. Both investments will earn
$5,000 with a probability
of 0.5 and $1,000 with a probability of 0.5. Investment A will use
100% equity financing
(issuing stocks). Investment B will get $30,000 through issuing
stocks and $30,000 through
issuing bonds. Investment B must pay 4% interest on the
bonds.
a. Calculate the expected returns on equity (returns after interest
payments divided by the
amount of equity) for Investment A and Investment B. Express the
returns as a percentage.
b. If the investments earned the lower amount ($1,000), what is the
rate of return on equity
for Investment A and Investment B? If the investments earned the
higher amount ($5,000),
what is the return on equity for Investment A and Investment
B?
c. Using your answers from ‘a’ and ‘b’, what is the standard
deviation of the rate of return
on equity in each case? Which investment has the highest expected
returns on equity?
Which has the lowest risk? What explains the difference in risk
between the two
investments?