Question

The common stock and debt of Android Corp. are valued at $44 million and $33 million, respectively. Investors currently require a 16% return on the common stock and an 8% return on the debt. There are no taxes.

1. If Android Corp. issues an additional $12 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 12.57%.

2. Suppose you prefer the original capital structure with a 16% return on the common stock and a WACC of 12.57%. If you have $3,000 to invest, how much should you invest in the stock and bonds of the restructured firm (which have returns of 19% and 8%, respectively) to obtain the same return as an investment in the stock of the original firm?

Answer 1

Ques 1) If Android Corp. issues $ 12 million of additional debt and retire $12 million of common stock. So the New Values will be

Common Stock $(44-12) = $32 million

Debt $ (33+12) = $ 45 million

Firstly it is givven that WACC is 12.57% which can be calculated as {(44 * 16 %) + ( 33 * 8%)}/ (44+33) = 12.57%

Return of common stock is 16% and debt is 8% using similar formula we have

WACC = {(32*16%)+(45*8%)}/(44+33) = (8.72/77) * 100 % = 11.324%

Question 2)

in this question we have to invest $ 3000 in 19% and 8% rate of return such that WACC is 12.57%

Suppose we invest $ 100y in common stock which yield 19% and $ (3000-100y) in debt which yield 8%

So,

{(100y * 19%) + [(3000-100y)*8%]}/3000 = 0.1257

11y + 240 = 377.1

y = 137.1/11

y = 12.4636

So Amount invested in common stock is $ 1246.36 and in debt is $ (3000-1246.36) = $ 1753.64