Question 1:
The common stock and debt of Northern Sludge are valued at $50 million and $30 million, respectively. Investors currently require a 16% return on the common stock and an 8% return on the debt. If Northern Sludge issues an additional $10 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 risk of the debt and that there are no taxes.
Data
Number of shares 1,000
Price per share $10
Market value of shares $10,000
Outcomes
Operating income ($) 500 1,000 1,500 2,000
Earnings per share ($) .50 1.00 1.50 2.00
Return on shares (%) 5 10 15 20
Expected outcome
Question 2:
Use above chart. Suppose that Ms. Macbeth's investment bankers have informed her that since the new issue of debt is risky, debt holders will demand a return of 12.5%, which is 2.5% above the risk-free interest rate.
a. What are rA and rE? b. Suppose that the beta of the unlevered stock was 0.6. What will βA, βE, and βD be after the change to the capital structure?