Question

Gaagle is a computer software company. The company has both debt and equity. The value of the company’s assets is $200 million.   The value of the company’s debt is $100 million. The beta of its debt is 0.4. The stock price is $20 per share. The dividend per share is expected to be $2 next year and is expected to grow at a rate of 6% each year in the future. The risk free rate is 4% and the market risk premium is 8%.

a. What is the expected return on Gaagle’s equity?  

b. What is Gaagle’s cost of capital?

Answer 1

a.as per dividend growth model:

stock price = (dividend next year/ (return on equity - growth rate)

=> $20 = $2 / (required return - 0.06)

=>required return - 0.06 = 0.10

=>required return on gaagle's equity = 0.16=>16%.

b.to know the cost of capital , we need to know the cost of debt.

cost of debt as per CAPM = risk free rate + beta *(market premium)

=>4% + 0.40*8%

=>7.2%.

we need to know the weights of debt and equity.

given total assets = $200 m

total debt = $100 m

total equity = $200 m assets- 100 m debt

=>$100 m

total of equity and debt = $100 m +100 m =>$200 m.

weight of debt = ($100 / $200) =>0.50.

weight of equity = ($100 / 200)=>0.50.

cost of capital = [weight of debt * cost of debt] + [weight of equity * cost of equity]

=> [0.50*7.2%] + [0.50*16%]

=>11.60%.