Question

The common stock and debt of Amazon are valued at $75 million and $125 million, respectively. Investors currently require a 13% return on the common stock and an 7% return on the debt. Assume that the change in capital structure does not affect the risk of the debt and that there are no taxes.

If Amazon issues an additional $40 million of common stock and uses this money to retire debt, what is the expected return on the stock? (Round your answer to 4 decimal places.)
Expected return on the stock	%

Answer 1

current D/E = 125/75 = 1.666

Levered cost of equity = Unlevered cost of equity+D/E*( Unlevered cost of equity-cost of debt)*(1-tax rate)

13 = Unlevered cost of equity+1.666*(Unlevered cost of equity-7)*(1-0)

Unlevered cost of equity = 9.25

new D/E = (debt-equity raised )/(equity+equity raised )

=(125-40)/(75+40)

=0.739

Levered cost of equity = Unlevered cost of equity+D/E*( Unlevered cost of equity-cost of debt)*(1-tax rate)

Levered cost of equity = 9.25+0.739*(9.25-7)*(1-0)

Levered cost of equity = 10.91