4 Leverage Part II time Casita Taqueria wants to go publie i

4. Leverage, Part II time). Casita Taqueria wants to go publie (ie. sell equity to the public for the first The investment bank that will underwrite the equity offering needs to assign a value to the company. An important part of this process is determining the correct cost o capital to discount all future cash flows of Casita Taqueria. The investment bank survey the taqueria industry and finds the following information for the three restaurants most similar to Casita Taqueria: Company Equity beta Debt beta Debt/Equity ratio 1.2 1.0 1.8 0.0 0.1 0.3 20% 25% 50% when Casita Taqueria goes public, they will issue debt that will represent 20% of their capital structure, and this debt will have Bp 0.1 The investment bank estimates that the market risk premium is 8% and the risk-free interest rate is 5%. (a) What is the estimate of Casita Taquerias cost of capital? [10 points] (b) What wil be the expected return on their equity after they go public? [10 points]

Solution

1.Before They go Public assuming 20% debt ratio , Equity beta =1.2 , Debt beta = 0
Asset Beta = Debt ratio * Beta Debt + Equity ratio * Beta Equity = 20%/(100% + 20%) * 0 + (100%/( 100% + 20%) )* 1.2 = 1
Cost of capital = Risk free rate + Beta asset * ( Market Risk - Risk free rate) = 5% + 1 * 8% = 13.00%


2. When Debt structure is 20% of capital struture the Debt equity ratio = 25%
Beta Debt = 0.1 , Beta Equity = 1
Asset Beta = Debt ratio * Beta Debt + Equity ratio * Beta Equity = 20% * 0.1 + 80% * 1 = 0.82
After they go public rate of return = Risk free rate + Beta asset * ( Market Risk - Risk free rate) = 5% + 0.82 * 8% = 11.56%

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