Sandy asked in Business & FinanceInvesting · 8 years ago

how do I figure out this return on equity question?

Two firms, Alpha, Inc., and Beta, Inc., are in the same business. Alpha, Inc., has debt that is viewed by the market as risk-less with a market value of $500 million. Beta, Inc., has no debt. Both firms are expected to generate cash flows of $100 million per year for the foreseeable future and the market value of the equity of Beta, Inc is $1 billion. Estimate the return on equity of Alpha, Inc. Assume there are no taxes, and the risk-free rate is 5%.

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  • 7 years ago
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    Assumption:

    With the exception of debt, both the companies are similar in all respects.

    A. Market Value of Equity of Alpha:

    (Market value of the Equity of Beta, Inc $1 billion - Market Value of Debt of Alpha $500 million) = $500 million

    B. Estimate of return on equity of Alpha, Inc:

    (Cash flows^^^ $100 million / Market value of Equity $500 million as at A)*100 = 20%

    ^^^ Net Income + Non Cash debits (i.e., depreciation, etc.)

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