Case Scenario:
Nikita Inc has a tradition of financing all their operations with equity issues. They have no debt in their capital structure. The market return on their equity is currently 14%, slightly below the return on the stock market as a whole, which is 15%. The risk free rate of interest is currently 5%. The share price is $27.50 per share, and the company has 10 million shares outstanding.
The new management of Nikita Inc has decided to break with the company's tradition and finance 10% of their operations with debt. This would still give the company a AAA credit rating, and the expected return on this debt would equal the risk free rate. The company would issue debt and use all the proceeds to repurchase some of their shares after re-levering. [This means the company’s assets do not change, only its capital structure.] show all work
Q1. What is the beta of Nikita Inc equity if all values above conform with the CAPM? (the question refers to Nikita Inc before relevering).
Q2. What is the equity beta after the company has repurchased the shares and issued debt?
Q3. What is the return on equity now?
Q4. How has this affected the company's cost of capital?
Q5. What is the dollar amount of debt the company has to issue?
Q6. How many shares does it repurchase?
Q7. Before undertaking any debt issue, Nikita Inc has discussed the matter at length with the institutional shareholders of the company. They strongly suggest that Nikita Inc increase its leverage so that the expected return on equity is at least 1% per year above the expected return on the market index. Is the planned recapitalization sufficient to achieve this goal? If not, determine how much debt (as a percentage of the value of the company) Nikita Inc should issue to satisfy institutional investors. Assume that at the new level of debt the debt will still be risk-free.