MacBeth Spot Removers is entirely equity financed. Use the following information:
Number of Shares = 1,700
Price per share = $24 Market value of shares = $40,800
Expected operating income = $6,120
Return on assets = 15%
MacBeth now decides to issue $20,400 of debt and to use the proceeds to repurchase stock. MacBeth's investment bankers have informed them that since the new issue of debt is risky, the debt holders will demand an expected return of 11.8%, which is 3.2% above the current risk-free interest rate.
a) What are return on assets and return on equity after the debt issue?
b) Suppose, additionally, that the beta of the unlevered stock was 0.60. What will Ba, Bd, and Be be after the capital structure change? (Hint: Use the cost of debt minus 3.2% to get the risk free rate. Use the unlevered beta and the cost of the unlevered equity (asset return) and the CAPM to estimate the market risk premium. Then use this market risk premium, the risk free rate, and the CAPM formula to back into the other betas.)