Ethier Enterprise has an unlevered beta of 1.0. Ethier is financed with 50% debt and has a levered beta of 1.6. If the risk free rate is 4.5% and the market risk premium is 5%, how much is the additional premium that Ethier's shareholders require to be compensated for financial risk?

Additional premium is 3%

Explanation:

Without debt the shareholders' rate is computed thus:

Ke=Rf+beta * (Mrp-Rf)

Ke=4.5%+1.0 * (5%)

Ke=9.50%

With debt financing added to the capital structure, the equity beta changes to 1.6, the shareholders' expected return is computed thus:

Ke=4.5%+1.6 * (5%)

Ke=12.5%

The additional premium required is the increase in expected return of 3% (12.5%-9.5%)

The 3% is to compensate the equity shareholders for taking the risk of getting little or no dividends at all because the debt-holders interest must be paid first