Question

Global Pistons (GP) has common stock with a market value of $380 million and debt with a value of $248 million. Investors expect a 16% return on the stock and a 8% return on the debt. Assume perfect capital markets. a. Suppose GP issues $248 million of new stock to buy back the debt. What is the expected return of the stock after this transaction? b. Suppose instead GP issues $63.04 million of new debt to repurchase stock. i. If the risk of the debt does not change, what is the expected return of the stock after this transaction? ii. If the risk of the debt increases, would the expected return of the stock be higher or lower than when debt is issued to repurchase stock in part (i)?

Answer 1

Given i stock Debt Ke = 16% - $ 380 million $ 248 million return on stock, kd=8% return of debt. a) Expected return of the stock after issuing $248 mil Stock to buy back debt, this will result into an all equity firm" therefore expected return of the stock will be the wACC, which is equal to 12,84% computation of WACC component $ in mil Ratio individual cost WACC a) Debt 248 248/628 8% (100-0)=8% 8%. X 248 = 3:16% 6) Equity / Stock 380 380/628 16% 16% 8380 = 9.68% Total 628 Ans 12.84% 62X

b) so the issue & 63.04 mil debt to repurchase stock new capital structure will be stock & (380 - 63.041) = 316.16mil - debt &(248 +63.04)= 311 oymil . Expected return of the stock will be According to 'M&M approach' Ke = kot Debt (ko-kd) Equity = 12.84% + 3 11.04 (12• 84%-8% 17.59% 316.96 As stated in the question it is assumed that perfect market exists, SO according to M&M approach States that the higher the risk the higher is the return expectation of equity investors. So if risk of debt il Kd f (increases) Ke will also ↑ (increase) due to higher financial risk A Product
This question is based on M &M approach.