Question

lobal Pistons​ (GP) has common stock with a market value of $ 490 million and debt with a value of $ 298 million. Investors expect a 12 % return on the stock and a 7 % return on the debt. Assume perfect capital markets. a. Suppose GP issues $ 298 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 $ 90.78 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

Solution

Stock $490 million, Debt $298 million, 12% return on stock, 7% return on debt

A. After issue of $298 million stock to buy back debt, the firm is an all equity firm. Expected return of the stock is WACC.

WACC should change after this transaction.

WACC =  (E/V * Re) + ((D/V *Rd) * (1-t))

= (490/788) *12% + (298/788) * 7%

= 10.11%

Return on stock is 10.11%

B.Issue 90.78 million of debt to repurchase stock;

Now stock : 399.22 million

debt : 388.78 million

1. Expected return of the stock after transaction?

re = ru + d / e(ru - rd)

= 10.11 + 399.22(10.11 - 7) / 388.78

= 13.30%

2. if the risk of the debt increases, risk expected return on the stock is lower. The debt will share some of the risk.