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?
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%.
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