Problem:
Hubbard's Pet Foods is financed 50% by common stock and 50% by bonds. The expected return on the common stock is 13.0%, and the rate of interest on the bonds is 7.0%. Assume that the bonds are default-free and that there are no taxes. Now assume that Hubbard's issues more debt and uses the proceeds to retire equity. The new financing mix is 35% equity and 65% debt.
Requirement:
Question 1: If the debt is still default-free, calculate the expected rate of return on equity?
Question 2: Calculate the expected return on the package of common stock and bonds?
Note: Provide support for rationale.