The equity and debt of a firm are valued at $50 and $30 million respectively. Investors require a return of 16% on equity and 8% on debt.

1. If the firm issues an additional $10 million in debt and it uses the funds to repurchase equity, what will happen to the expected return on equity? (Assume that M&M assumptions hold and that the return on debt does not change)

2. If the risk of debt decreased, would your answer underestimate or overestimate the

expected return on equity?