Hubbards Pet Foods is financed 50% by common stock and 50% by bonds. The expecte

Question

Hubbards Pet Foods is financed 50% by common stock and 50% by bonds. The expected return on the common stock is 13.0%, and the rate of interest on the bonds is 7.0%. Assume that the bonds are default-free and that there are no taxes. Now assume that Hubbards issues more debt and uses the proceeds to retire equity. The new financing mix is 35% equity and 65% debt.

If the debt is still default-free, calculate the expected rate of return on equity? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Calculate the expected return on the package of common stock and bonds? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Hubbards Pet Foods is financed 50% by common stock and 50% by bonds. The expected return on the common stock is 13.0%, and the rate of interest on the bonds is 7.0%. Assume that the bonds are default-free and that there are no taxes. Now assume that Hubbards issues more debt and uses the proceeds to retire equity. The new financing mix is 35% equity and 65% debt.

Explanation / Answer

Initial return is ( 7 * 50 + 13 * 50 ) / 100 = 10%

Now,

with 65% debt,

0.65 * 7 + 0.35*x = 10

x = 15.57%

The return on package of common stock and bonds is 10%

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