Question
In: Finance
The common stock and debt of Northern Sludge are valued at $120 million and $80 million,...
| The common stock and debt of Northern Sludge are valued at $120 million and $80 million, respectively. Investors currently require a 14% return on the common stock and an 8% return on the debt. Assume that the change in capital structure does not affect the risk of the debt and that there are no taxes. |
| If Northern Sludge issues an additional $15 million of common stock and uses this money to retire debt, what is the expected return on the stock? (Round your answer to 4 decimal places.) | |
| Expected return on the stock | % |
Solutions
Expert Solution
Before Issuance of new common stock:
Value of Firm = Value of Equity + Value of Debt
Value of Firm = $120 million + $80 million
Value of Firm = $200 million
Weight of Debt = Value of Debt / Value of Firm
Weight of Debt = $80 million / $200 million
Weight of Debt = 0.40
Weight of Equity = Value of Equity / Value of Firm
Weight of Equity = $120 million / $200 million
Weight of Equity = 0.60
Return on Assets = Weight of Debt * Cost of Debt + Weight of
Equity * Cost of Equity
Return on Assets = 0.40 * 8.00% + 0.60 * 14.00%
Return on Assets = 11.60%
After Issuance of new common stock:
Value of Equity = $120 million + $15 million
Value of Equity = $135 million
Value of Debt = $80 million - $15 million
Value of Debt = $65 million
Debt-Equity Ratio = Value of Debt / Value of Equity
Debt-Equity Ratio = $65 million / $135 million
Debt-Equity Ratio = 0.4815
Return on Equity = Return on Assets + [(Return on Assets -
Return on Debt) * Debt-Equity Ratio]
Return on Equity = 0.1160 + [(0.1160 - 0.0800) * 0.4815]
Return on Equity = 0.1160 + 0.0173
Return on Equity = 0.1333 or 13.33%
jeff jeffy answered 1 year agoRelated Solutions
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