Company has an Unlevered beta of 1.1. Financed with 50% debt and levered beta of

Question

Company has an Unlevered beta of 1.1. Financed with 50% debt and levered beta of 1.6. If the risk free rate is 5.5% and the market risk premium is 5% how much is the additional premium that shareholders are required to be compensated for financial risk? Company has an Unlevered beta of 1.1. Financed with 50% debt and levered beta of 1.6. If the risk free rate is 5.5% and the market risk premium is 5% how much is the additional premium that shareholders are required to be compensated for financial risk?

Explanation / Answer

If the company had no debt, its required return would be:

            rs,U = rRF + bU RPM = 5.5% + 1.0(5%) = 10.5%.

            With debt, the required return is:

            rs,L = rRF + bL RPM = 5.5% + 1.6(5%) = 13.5%.

            Therefore, the extra premium required for financial risk is 13.5% - 10.5% = 3%.

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