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Leverage, Risk and Cost of Capital

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Global Pistons (GP) has common stock with a market value of $200 million and debt with a value of $100 million. Investors expect a 15% return on the stock and a 6% return on the debt. Assume perfect capital markets.

a. Suppose GP issues $100 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 $50 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 in part (i)?

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Leverage, risk and cost of capital are assessed.

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