The common stock and debt

The common stock and debt

The common stock and debt of Northern Sludge are valued at $50 million and $30million, respectively. Investors currently require a 16% return on the firm?s commonstock and 8% on its debt. If Northern Sludge issues an additional $10 million of commonstock and uses this money to retire (i.e., to pay back) debt, what is the expected return onits common stock?Assume first that the change in capital structure does not affect the risk of the debt.Suppose next that the change in capital structure increased the risk of the debt. Wouldyour previous answer then under- or overstate the effect on the expected return on thefirm?s common stock?Assume throughout that the MM assumptions hold (i.e., no taxes, no costs of financialdistress).

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