The common stock and debt of Northern Sludge are valued at $60 million and $40 m
ID: 2706720 • Letter: T
Question
The common stock and debt of Northern Sludge are valued at $60 million and $40 million, respectively. Investors currently require a 16.7% return on the common stock and a 7.0% return on the debt. If Northern Sludge issues an additional $18 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. Round your answer to 2 decimal places.)
The common stock and debt of Northern Sludge are valued at $60 million and $40 million, respectively. Investors currently require a 16.7% return on the common stock and a 7.0% return on the debt. If Northern Sludge issues an additional $18 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. Round your answer to 2 decimal places.)
Explanation / Answer
PREVIOUS WEIGTHED AVERAGE RETURN EARNED BY INVESTORS = [60*16.7 + 40*7]/(60+40)
=12.82%
NOW IF THE RETURN OF 12.82% IS MAINTAINED
let new return on common stock be Re
12.82 = [(60+18)*Re + (40-18)*7]/100
Re = 14.46%
therefore new return on equity = 14.46%