5. Comparing equity financing with debt financing. Consider two $60,000 investments – call them Investment A...

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?

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jeff jeffy answered 1 year ago

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