Final answer:
The expected return on equity for Windows Phone Corp. will likely increase after issuing more debt to retire common stock, because the cost of equity carries more weight in the WACC after the restructuring.
Step-by-step explanation:
When Windows Phone Corp. issues an additional $8 million of debt and uses this money to retire common stock, the expected return on the remaining stock (equity) is impacted. To compute the new expected return on equity, one needs to use the Weighted Average Cost of Capital (WACC) formula, which reflects the cost of each component of capital, each weighted by its proportion in the overall capital structure.
However, to give a precise computation, we would need the initial amounts of equity and debt before the new issue, which is not provided in the question. Without taxes and assuming the risk of debt does not change, the expected return on equity will increase as debt increases due to the financial leverage effect. In such a case, issuing debt to repurchase equity can potentially lower the WACC while increasing financial risk, ultimately aiming for a balance that maximum shareholder value.
Given that investors require a 19% return on the common stock and a 9% return on the debt, and the WACC under the initial capital structure is 14.92%, these rates of return indicate the cost of equity and the cost of debt. The WACC can change based on the new capital structure, potentially leading to a different leverage ratio and thus changing the return expected by equity investors.
The Modigliani-Miller theorem, in a world without taxes, suggests that the capital structure does not affect a company's value, but since investors are typically risk-averse, they may require a higher return on equity as more debt is introduced due to the increased financial risk. Therefore, one would expect the return on equity to increase due to the more heavily weighted cost of equity in the WACC calculation post-restructuring.