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The common stock and debt of Northern Sludge are valued at $50 million and $30 million,...

Question:

The common stock and debt of Northern Sludge are valued at $50 million and $30 million, respectively. Investors currently require a 16% return on the common stock and an 8% return on the debt. If Northern Sludge issues an additional $10 million of common stock and uses this money to retire debt, what happens to the expected return on the stock? Assume that the change in capital structure does not affect the risk of the debt and that there are no taxes.

Capital Structure Dynamics:

This question relates to a firm's capital structure, the mix of debt and equity financing strategically utilized to finance a firm's operations and growth. Depending on business dynamics and industry, capital structures can vary widely from firm to firm. Highly leveraged firms (lots of debt) are generally considered riskier businesses, but firms with 100% equity capital often find it difficult to generate adequate rates of return. Incidentally, debt involves the issuance of loans and bonds. Equity involves the issuance of stock or the use of retained earnings (self-financing).

Answer and Explanation:

This problem provides various financial figures, but we can answer the question without any computations. Logical thought will suffice, as outlined below.

- First, be cognizant of the fact debt financing is generally cheaper than equity financing, especially when considering the tax deductibility of interest expense.

- Second, be aware that an increasingly large amount of debt increases the incremental cost of debt as well as the incremental cost of equity. This holds true, because with each additional dollar of interest expense, earnings become less predictable and potentially more volatile. Volatile earnings and cash flows necessitate a higher cost of debt and a higher cost of equity for new investors.

- Based on the ideas above, if Northern Sludge issues an additional $10 million of common stock and retires an equal amount debt, the expected return on the stock will be reduced. The financing action has effectively reduced the volatility of the firm's earnings, thereby reducing the risk premium required by equity investors.


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Capital Structure & the Cost of Capital

from Finance 101: Principles of Finance

Chapter 15 / Lesson 1
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