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Problem on required rate of return

Tudor Online Publishing Corporation has tax rate of 35%, debt-to-equity ratio of 25%, and has (leveraged) beta 1.25. The riskless rate is 3% and the market return is 12%. Windsor Publishing Company is an all equity company and is in the same business. What is the required rate of return by the Windsor stockholders?

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Expert

Verified

Bu = BL/(1 + (1 – T)(D/E)) = 1.25/(1 + (1 – 0.35)(0.25) = 1.25/1.1625 = 1.075

Hence with a D/E ratio of 0,
BL = BU (1 + (1 – T)(D/E)) = BU = 1.075

Cost of equity = 3% + 1.075*(12% - 3%) = 12.68%
Cost of debt = 0 (since no debt)

WACC = Cost of equity = 12.68%

Thus required rate of return is 12.68%

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