Question

Use the following information for questions 12-18.

For the purpose of this question, the current date is Dec 31^st, 2014.DownScale, Inc is a diet marketing company which sells books, supplements, and diet foods. It has after-tax earnings in 2014 of $200M or $4.00 earnings per share (50m shares outstanding), and a tax rate of 30%. It also has $500M in debt on which it pays $25M in interest annually. Dividends of $1.30 per share were paid on December 30, 2014. Its stock price was $60 per share on December 31, 2014.  DownScale’s equity beta is 1.2. The risk free rate is 3% and the risk premium on the market is 6%.

12. What return do investors expect on DownScale’s stock (i.e. CAPM)? Round to the nearest tenth of a percentage point (i.e. enter 12.3% as 0.123)

13. What is DownScale’s market capitalization on December 31, 2014? Round to the nearest whole dollar.

14. What is the current P/E ratio of DownScale on Dec 31^st, 2014? Round to one decimal place.

15. What is the current dividend yield (based on the most recent dividend) of DownScale on Dec 31^st  2014? Round to the nearest tenth of a percentage point (i.e. enter 12.3% as 0.123)​​​​​​​

16. What is DownScale’s weighted average cost of capital (WACC)? Round to the nearest tenth of a percentage point (i.e. enter 12.3% as 0.123)​​​​​​​

17.  What is the discount rate DownScale should use to value a new line of books, in line with its current company risk profile?

The expected return on DownScale’s stock (your answer from #12), since the company should finance the investment with a new stock offering given its low stock price

The risk-free rate, since the investment is small, and doesn’t represent much risk to the company

The WACC (your answer from Question #16), since the new product is in line with its current risk profile

The non-WACC discount rate calculated by using the averaged un-levered betas of comparable book publishers in the CAPM formula, since the project doesn’t represent the industry in which the company currently operates

The interest rate on its debt of 4.5%, since the company should finance the investment with a new debt offering given its low debt to equity ratio

The Market Risk Premium of 6%, since on average, this is the premium that risky investments earn above the risk-free rate

18. If DownScale desired to begin building gyms it should use a rate lower then the WACC calculated in Question #16 because this would be considered to be a safe project.

True or False

Answer 1

1-	required rate of return	risk free rate+(market risk premium)*beta	3+(6)*1.2	10.2
2-	market capitalization in millions	no of stock issued* market price	50*60	3000
3-	PE ratio	market price/EPS	60/4	15
4-	current dividend Yield	dividend/market price	1.3/60	0.022
5-	WACC
source	value	weight	cost	weight*cost
debt	500	0.142857143	3.5	0.5
equity	3000	0.857142857	10.2	8.742857143
total	3500	WACC = weight*cost		9.242857143
after tax cost of debt	before tax debt*(1-tax rate)	(25/500)*(1-.3)	3.5%
6-	The WACC (your answer from Question #16), since the new product is in line with its current risk profile
7-	FALSE