Q11

(Lecture note chapter 17 MM proposition 1 pages 9-18) Learn and Earn Company is financed entirely by common stock that is priced to offer a 20% (=$12/$60) expected rate of return. The stock price is $60 and the earnings per share are $12. The company wishes to repurchase 50% of the stock and substitutes an equal value of debt yielding 8%. Suppose that before refinancing, an investor owned 100 shares of Learn and Earn common stock. If an investor wishes to ensure that risk and expected return on his investment are unaffected by this refinancing, he sold 50 shares and purchased $3,000 of 8% debt (bonds). Prove that the new expected return for him will remain at 20% (1)