Question 1the common stock and debt of northern sludge are

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Reference no: EM13381077

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?

Reference no: EM13381077

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