The company ROC has been financing its operations with equity only. That is, it is fully financed with equity. The expected return on their equity is currently 8%, the share price is $20 per share, and there are 25 million shares outstanding. The market risk premium is 6%. The risk free rate is 4%. Assume that the tax rate is zero.
(a) What is ROC’s equity beta?
(b) What is the company’s cost of capital?
The CEO of ROC has decided to change the capital structure. He is planning to finance 25% of their operations with debt. Assume that the debt is still risk free after the refinancing. The company would issue debt and use all the proceeds to repurchase some of their shares after relevering. Assume that the tax rate is zero.
(c) What is the expected return on equity now?
(d) What is the dollar amount of debt the company has to issue?
(e) How many shares does it have to repurchase?
(g) Now assume that ROC wants the expected return on equity to be equal to 2% p.a. above the expected return on the market portfolio. If so, how much debt ROC should issue for the recapitalization in order to achieve this new goal? Assume that at the new level of debt the debt will still be risk-free.
(h) Now assume that ROC is still unlevered. Now ROC is considering the following plan: it is planning to acquire additional production facilities with a cost of $200 million. The new facilities will have identical systematic risk as the current assets of ROC. It is to issue $100million in debt and another $100million in equity. What is the asset beta of ROC now? What is the expected return on equity now? Assume that the debt is still risk free.