The common stock and debt of Northern Sludge are valued at $63 million and $37 m
ID: 2736359 • Letter: T
Question
The common stock and debt of Northern Sludge are valued at $63 million and $37 million, respectively. Investors currently require a return of 15.7% on the common stock and 8.0% on the debt. If Northern Sludge issues an additional $16 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.)
The common stock and debt of Northern Sludge are valued at $63 million and $37 million, respectively. Investors currently require a return of 15.7% on the common stock and 8.0% on the debt. If Northern Sludge issues an additional $16 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.)
Explanation / Answer
Company's Risk of Debt not effected and there is no tax hence expected return on assets will not change.
Expected return on Assets= Sum of Weighted average return of Debt and equity
rA = (0.08*37/100)+ (0.157*63/100)= 12.85%
NOW THE COMPANY HAS TO ISSUE $16 Million equity to retire debt.
New Equity= $63+$16= $79 million
New Debt= $37-$16= $21 million
Weight of Equity= 79/100
Return on Assets= 12.85%
New expected return on stock= ROA*Weight of stock
= 12.85*79/100= 10.15%