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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. 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
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%