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Homework answers / question archive / The common stock and debt of Northern Sludge are valued at $56 million and $44 million, respectively

The common stock and debt of Northern Sludge are valued at $56 million and $44 million, respectively

Finance

The common stock and debt of Northern Sludge are valued at $56 million and $44 million, respectively. Investors currently require a 16.8% return on the common stock and a/an 6.9% return on the debt. If Northern Sludge issues an additional $20 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 interest rate on Northern's debt and that there are no taxes. (Do not round intermediate calculations. Enter your answer as a percent rounded to two decimal places.) 
New return on equity 

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First, We calculate WACC:

WACC = (Weight of Equity*Cost of Equity)+(Weight of Debt*Cost of Debt)

Here,

Weight of Equity = $56 millions / ($56 millions + $44 millions) = $56 millions / $100 millions = 0.56

Cost of Equity = 16.8%

Weight of Debt = $44 millions / ($56 millions + $44 millions) = $44 millions / $100 millions = 0.44

Cost of Debt = 6.9%

 

WACC = (0.56*16.8%)+(0.44*6.9%)

= 0.09408 + 0.12444

WACC = 0.12444 or 12.44%

 

Change in capital structure do not change risk of debt.

So, firm value will not change and cost of capital shall remain same after change in capital structure.

New Equity = $20 million

So, Equity in Total = $56 million+ $20 million = $76 million

Debt retired for $20 million. So debt remaining = $44 million-$20 million = $24 million

so, Weight of debt = 24/(76+24)= 0.24

and weight of Equity is 76/(24+76)= 0.76

Assume Expected Return in Equity is x

 

WACC = (Weight of Equity*Cost of Equity)+(Weight of Debt*Cost of Debt)

0.12444 = (0.76*x)+(0.24*0.069)

0.12444 -(0.24*0.069) = 0.76x

0.12444 - 0.01656 = 0.76x

0.10788 = 0.76x

x = 0.10788/0.76

x = 0.14195

So, New Expected Return on Equity is 0.14195 or 14.19%