Northern Sludge currently has $56 million in stock and $44 million in debt. The stock requires a 16.8% return and debt a 6.9% return. If Northern Sludge issues $20 million more in stock to retire $20 million in debt, the expected return on stock will decrease to 13.78% due to the lower risk from less debt.

1. The common stock and debt of Northern Sludge are valued at $56 million and $44 million,
respectively. Investors currently require a return of 16.8% on the common stock and 6.9% on the
debt. If Northern Sludge issues an additional $20 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. (Do not round
intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.) The
common stock and debt of Northern Sludge are valued at $56 million and $44 million,
respectively. Investors currently require a return of 16.8% on the common stock and 6.9% on the
debt. If Northern Sludge issues an additional $20 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. (Do not round
intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.) New
return on equity
Solution
Answer :
Equity = 76 Million
Debt = 24 Million
Expected Return on Assets = 0.069 *( 44/100) + 0.168 * (56/100) = 12.45%
New Return on Equity = 0.1245+(24/100)*(0.1245-0.069) = 13.78%