Leverage

Smart Stay is a hotel that is currently financed with 30% debt. The debt expected return is 6%. The expected rate of return on Smart Stay's equity is 16%. The expected return on the stock market index is 16%. Suppose the risk-free rate is 6% and Smart Stay has 50 million shares outstanding for a price of $5 per share.

For answering the following questions, assume all assets are priced on the CAPM security market line (SML).

(a) (6 points) What is the cost of capital of Smart Stay?

(b) Suppose the CFO wishes to realize a target equity expected return of 24% through leveraging and paying all the proceeds as a special dividend.

i) (3 points) Calculate the equity beta that the CFO should target.

ii) (4 points)How much debt should the company issue, assuming that all debt can be issued at an expected return equal to 8%? What is the cost of capital now?

iii) (2 point) Has shareholders' wealth changed due to taking on the additional debt?