Question

Please show the calculation.

Global Pistons (GP) has common stock with a market value of $520 million and debt with a value of $234 million. Investors expect a 20% return on the stock and a 11% return on the debt. Assume perfect capital markets. a. Suppose GP issues $234 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 $115.00 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

a. Expected return of stock = 20% x ($520 million + $234 million) = $150.8 million

b. i) Expected return of stock = 20% x ($520 million - $115 million) = $81 million
b. ii) If the risk of debt increases, the expected return of the stock will be higher.

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