Question

Global Pistons​ (GP) has common stock with a market value of $ 430 million and debt with a value of $ 249 million. Investors expect a 13 % return on the stock and a 5 % return on the debt. Assume perfect capital markets. a. Suppose GP issues $ 249 million of new stock to buy back the debt. What is the expected return of the stock after this​ transaction, round to two decimal places? b. Suppose instead GP issues $ 55.12 million of new debt to repurchase stock. i. If the risk of the debt does not​ change, what is the expected return of the stock after this​ transaction? ii. If the risk of the debt​ increases, would the expected return of the stock be higher or lower than when debt is issued to repurchase stock in part ​(i​)?

Answer 1

Soln : Stock value , S = $430 mn, debt value , D = $249 mn

return on equity, r = 13%, return on debt, R = 5%

Lets calculate the WACC of the firm i.e. Weighted average cost of capital

WACC = S*r/(S+D) + D*R/(S+D)...........................please note we are considering that return on debt is given after tax.

WACC = 430*13/(430+249) + 249*5/(430+249) = 10.07%

a) Let the company issued new stock of $249 million to buy back the debt i.e. debt = 0

So, let r_e be the return on equity

again using the WACC eqn, we can say that as debt will be 0. So, return on equity will be equal to WACC .

So, r_e = 10.07%

b) Now, GP issues 55.12 million to buy back stock of same value.

Hence, new value of S = 430-55.12 = $374.88 and new value of debt, D = 249+ 55.12 = $304.12

So, again WACC =  S*r/(S+D) + D*R/(S+D)

10.07 = 374.88*r/679 + 304.12*5/679

On solving we get r = 14.18% (approx.)

b-ii) if risk of the debt increases, means the return will also increase on it. That makes the expected return on equity lower than what is there in part (i) to keep the WACC same.