Question: Assume M&M holds. Your firm has a total enterprise value of $200m. Its publically traded equity has a market value of $100m and its publically traded debt has a market value of $100m. The expected return on the firm's equity is 20% and the expected return on the firm's debt is 5%. The equity beta is 1.3 and the debt beta is 0.6. The risk free rate is 5%. Assume there are no taxes. What is the firm's overall expected return?
Now assume your firm takes out an additional $50m in debt and buys back $50m in stock. This causes the return on debt to increase to 7%. In an M&M world, how will this change affect the firm's WACC, the expected return on the firm's new assets? How does the change in leverage affect the firm's return on equity?