Question

Global Pistons​ (GP) has common stock with a market value of

$ 310 million and debt with a value of $ 175 million. Investors expect a 15 % return on the stock and a 9 % return on the debt. Assume perfect capital markets.

a. Suppose GP issues $ 175 million of new stock to buy back the debt. What is the expected return of the stock after this​ transaction?

b. Suppose instead GP issues $ 61.93 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

Answer :

(a.) Calculation of Expected Return of the stock after this transaction :

Expected Return of the stock after this transaction is same as Weighted Average Cost of Capital (WACC)

WACC = [Expected Return of Stock * Weight of Stock ) + (Return on Debt * Weight of Debt)

Weight of Stock = Market Value of Stock / Total Market value of Stock & Debt

= 310 / (310 + 175)

= 0.63917525773 or 0.6392

Weight of Debt = Market Value of Debt / Total Market value of Stock & Debt

= 175 / (310 + 175)

= 0.36082474226 or 0.3608

WACC = (Expected Return of Stock * Weight of Stock ) + (Return on Debt * Weight of Debt)

= (15% * 0.63917525773 ) + (9% * 0.36082474226)

= 9.5876% + 3.2474%

= 12.8350%

Expected Return = 12.8350%

(b.) (i) Suppose instead GP issues $ 61.93 million of new debt to repurchase stock. calculation of  expected return of the stock after this​ transaction :

Expected Return= Expected Return on Unlevered Firm+{(Debt / Equity)*(Return on unlevered firm-Return on Debt)}

Expected Return on unlevered Firm = 12.8350%

Debt = 175 + 61.93 = 236.93

Equity = 310 - 61.93 = 248.07

Expected Return=12.8350% + {( 236.93 / 248.07 )*(12.8350% - 9%)}

= 12.8350 % + 3.6628%

= 16.4978% or 16.50%

(ii) If the risk of Debt increses then cost of debt will be higher and return on stock will be lower as debt will share some of the risk . Therefore expected return of the stock be lower when debt is issued to repurchase stock in part (i)