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Assume M&M holds. Your firm has a total enterprise value of $200m. Its publically traded equity has a market value of $100m and its publically traded debt has a market value of $100m. The expected return on the firm's equity is 20% and the expected return on the firm's debt is 5%. The equity beta is 1.3 and the debt beta is 0.6. The risk free rate is 5%. Assume there are no taxes. What is the firm's overall expected return?

Now assume your firm takes out an additional $50m in debt and buys back $50m in stock. This causes the return on debt to increase to 7%. In an M&M world, how will this change affect the firm's WACC, the expected return on the firm's new assets? How does the change in leverage affect the firm's return on equity?

Financial Management, Finance

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