The common stock and debt of Northern Sludge are valued at $66 million and $34 m
ID: 2613528 • Letter: T
Question
The common stock and debt of Northern Sludge are valued at $66 million and $34 million, respectively. Investors currently require a return of 15.6% on the common stock and 8.1% on the debt.
If Northern Sludge issues an additional $17 million of common stock and uses this money to retire debt, what happens to the expected return on the stock? Assume that the change in capital structure does not affect the risk of the debt and that there are no taxes. (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)
What is new return on equity %
Explanation / Answer
Expected return on assets is:
R(assets)=(0.081*34/100)+(0.156*66/100)=0.02754+0.10296=0.1305=13.05%
The new return on equity is:
R equity=r assert+[D/E*(r assert*r debt)]
=0.1305+[17/83*(0.1305*0.081)]
= 0.1305+17/83*0.0105705
=0.10567 or10.567%