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GH Company has $5000 of debt and $20,000 of equity. GH pays 5% interest on all of itsdebt. GH has an equity beta of 2. The market risk premium is 5.5% and the risk free rateof return is 2%. WJK has a 30% marginal tax rate.a. What is WJK’s Unlevered Beta?b. How much of the expected rate of return on equity is due to asset risk?c. How much of the expected rate of return on equity is due to financial leverage?

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Answer:

Unlevered Beta = BL / [1 + ((1 - Tax Rate) x Debt/Equity)]

Debt/Equity= 5,000/20,000=0.25

=2/ [1 + ((1 - 0.3) *0.25)]

=1.702

Expected return on equity due to asset risk = Unlevered Beta * Market Risk premium

=1.702*5.5=9.361% of return on equity is due to asset risk

Expected return on  equity due to financial leverage= (Beta-Unlevered Beta)*market risk premium

=(2-1.702)*5.5=1.639% of return on equity is due to financial leverage.

Explanation:

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