2. The current debt-to-equity ratio of ABC Inc. is 0.3. Investors currently require a 20% return on the common stock and a 10% return on the debt. The company plans to issue some additional debt and uses the proceeds to repurchase its common stocks. This refinancing is expected to change its debt-to-equity ratio to 0.6. The corporate tax on this firm is 35%. Assume that the change in capital structure does not affect the risk of the debt and that capital markets are perfect and no bankruptcy costs.

a. What will happen to the expected return on the stock after the refinancing? Compare it to the original cost of equity and explain the difference.

b. If the risk of the debt did change, would your answer from the above question (a) underestimate or overestimate the expected return on the stock? Explain.