Question

If Windows Phone Corp. issues an additional $9 million of debt and uses this money to retire common stock, what will be the expected return on the stock? Recall that the WACC under the inital capital structure is 7.86. Assume that the change in capital structure does not affect the risk of the debt. Enter your answer as a percentage rounded to two decimal places. Do not include the percentage sign in your answer. valued at $48 million and $31 million

investors require 11%
common stock and a 3% return on debt. no taxes

Answer 1

The expected return on the stock, after Windows Phone Corp. issues an additional $9 million of debt to retire common stock, is 9.28%.

Step-by-step explanation:

When Windows Phone Corp. issues an additional $9 million of debt and uses this money to retire common stock, the expected return on the stock can be calculated using the Weighted Average Cost of Capital (WACC) formula. The WACC under the initial capital structure is 7.86%. The formula for WACC is:

WACC = (Weight of Debt * Cost of Debt) + (Weight of Equity * Cost of Equity)

In this case, the debt is retired using the additional debt issued, so the weight of debt becomes 0. The weight of equity becomes the initial equity value divided by the new total capital structure:

Weight of Equity = Common Stock Value / (Common Stock Value + Additional Debt)

Substituting the values into the WACC formula, we can calculate the expected return on the stock:

Expected Return on Stock = (Weight of Equity * Cost of Equity)

Let's calculate the expected return:

Common Stock Value = $48 million

Additional Debt = $9 million

Total Capital Structure = Common Stock Value + Additional Debt = $48 million + $9 million = $57 million

Weight of Equity = $48 million / $57 million = 0.8421

Cost of Equity = 11%

Expected Return on Stock = 0.8421 * 11% = 9.2757%

Therefore, the expected return on the stock will be 9.28%.