Question

Q.1 River Cruises is all-equity-financed with 100,000 shares. It now proposes

to issue $150,000 of debt at an interest rate of 10% and use the proceeds to repurchase 15,000 shares at $10 per share. Profits before interest are expected to be $120,000.

a. What is the ratio of price to expected earnings for River Cruises before it borrows the $150,000? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

b. What is the ratio after it borrows? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Q.2 The common stock and debt of Northern Sludge are valued at $64 million and $36 million, respectively. Investors currently require a return of 16.6% on the common stock and a return of 7.4% on the debt. If Northern Sludge issues an additional $18 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 interest rate on Northern’s debt and that there are no taxes. (Do not round intermediate calculations. Enter your answer as a whole percent.)

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