Question

Global Pistons​ (GP) has common stock with a market value of

$ 310 million and debt with a value of $ 157million. Investors expect a

15 % return on the stock and a 7 %

return on the debt. Assume perfect capital markets.

a. Suppose GP issues $157

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 $54.46

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​)?

a. Suppose GP issues $157

million of new stock to buy back the debt. What is the expected return of the stock after this​ transaction?

If GP issues $157

million of new stock to buy back the​ debt, the expected return is

--------------%. (Round to two decimal​ places.)

b. Suppose instead GP issues   $54.46 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?

If GP issues $ 54.46 million of new debt to repurchase stock and the risk of the debt does not​ change, the expected return is

___________​%. (Round to two decimal​ places.)

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​)?

​ Higher

Lower

Answer 1

a. GP Issues $157 million debt to buyback shares.
Now the firm becomes an All Equity firm. Effectively, the return on the equity is in fact WACC now.

Equity + Debt = 157 + 310 = 467

WACC = r_U(Unlevered Return) = (310/467) x 15% + (157/467) x 7% = 12.31%

b. New Equity = 310 - 54.46 = 255.54
New Debt = 157 + 54.46 = 211.46

Expected Return after the transaction = r_U + (D/E) x (r_U - r_D) = 12.31% + (211.46/255.54) x (12% - 7%)
= 12.31% + 4.14% = 16.45%

If r_D is higher, equity return is lower as the debt shares some of the risk