The Dogma Daycare has $750 debt outstanding with pretax cost of 6 percent and it
ID: 2383528 • Letter: T
Question
The Dogma Daycare has $750 debt outstanding with pretax cost of 6 percent and its common stock has a market value of $1,250. Dogma’s equity beta is currently 1.77. Dogma faces a corporate tax rate of 35 percent. The current risk free rate is 0.2 percent while the expected equity market risk premium is 8 percent.
A. Calculate Dogma's current cost of equity?
B. What is Dogma’s weighted average cost of capital?
C. What is Dogma's NOI? Assuming the NOI is a constant perpetuity.
D. Calculate Dogma's unlevered cost of equity?
E. Dogma is recapitalizing by issuing $250 in debt and using the proceeds to buy back stock. What is the new value of the firm’s debt and equity?
F. After the recapitalization, what is Dogma’s required return on equity and WACC?
g. Dogma now announces instead of issuing $250 in debt, the firm will reduce leverage by issuing $250 of equity and buyback $250 of debt. What is the value of the firm’s debt and equity under this scenario?
Explanation / Answer
a)cost of equity = Rf + beta *risk premium
= .2 + 1.77 * 8
= .2 + 14.16
= 14.36%
b)Total debt and equity outstanding = 750 + 1250 =$ 2000
weight of debt = 750 /2000 = .375
weight of equity = 1250 /2000 = .625
WACC =( after tax cost of debt *Wd ) +(Cost of equity *We)
= [6(1-.35) *.375 ] +[14.36 * .625]
= [3.9 *.375] + [14.36*.625]
= 1.4625 + 8.975
= 10.44% approx
c) NOI = Value of firm * WACC
= 2000 * 10.44%
= $ 208.80
D) WACC = unlevered cost of equity (1 - current debt ratio *tax)
10.44 = X(1 -.375*.35)
10.44 = X( 1- .1313)
10.44 = X(.8687)
cost of unlevered equity(X) = 10.44 /.8687
= 12.02%
E) value of debt = 750 + 250 = $ 1000
value of equity = 1250 -250 =$ 1000
F) requIRed return on equity = say assume 12%
WACC= (3.9 * .50) +(12*.50)
= 1.95 + 6
= 7.95%
g)Value of debt = 750 - 250 = 500
value of equity = 1250+ 250 = 1500
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