Question

The common stock and debt of iOS Corp. are valued at $73 million and $34 million, respectively. Investors currently require a 11% return on the common stock and an 7% return on the debt. There are no taxes. Calculate the weighted average cost of capital. WACC= 9.72 Correct response: 9.73

If iOS Corp. issues an additional $13 million of debt and uses this money to retire common stock, what will be the expected return on the stock? Assume that the change in capital structure does not affect the risk of the debt, and recall that the WACC under the initial capital structure is 9.73%.

answer whats in bold^

Answer 1

Initial WACC = 73/(73+34)*11%+ 34/(73+34)*7% = 0.097289 or 9.73%

As per MM theory (without taxes), the change in capital structure will not affect the value of the firm or the WACC. Hence, after change in capital structure

Value of debt = $34+$13 = $47 million

Value of equity = $73-$13 = $60 million

So, WACC = 47/(47+60)*7%+ 60/(47+60)*Ke where Ke is the cost of equity or expected return on stock

=> 9.73% = 47/(47+60)*7%+ 60/(47+60)*Ke

Ke = 0.118667 or 11.87%

Alternatively

Ke= WACC + (WACC- kd)* D/E

=9.73%+ (9.73%-7%)*47/60

=11.87%  

So, expected return on stock will be 11.87%