The common stock and debt of Northern Sludge are valued at $64 million and $36 m
ID: 2737224 • Letter: T
Question
The common stock and debt of Northern Sludge are valued at $64 million and $36 million, respectively. Investors currently require a return of 16.6% on the common stock and 7.1% 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.)
New return on equity? %
Explanation / Answer
Total Capital = $64 million + $36 million = $100 million
Weight of current equity = $64 million / $100 million = 0.64 or 64%
Weight of current debt = $36 million / $100 million = 0.36 or 36%
Current WACC = (0.64 x 0.166) + (0.36 x 0.071) = 0.1318 or 13.18%
New equity after issue = $64 million + $16 million = $80 million
Weight of new equity = $80 million / $100 million = 0.80 or 80%
New debt after issue = $36 million - $16 million = $20 million
Weight of new debt = $20 million / $100 million = 0.20 or 20%
As the risk of debt is not changing, so the WACC will also not change. So, the new return on equity:
0.1318 = (0.80 x ER) + (0.20 x 0.071)
0.1318 – 0.0142 = 0.80ER
ER = (0.1318 – 0.0142) / 0.80 = 0.147 or 14.7%
So, new return on equity will be 14.7%