Question

Air North has the following balance as of today:

Bond coupon rate=8%; coupon payment annual;                                          ($million)

Remaining term to maturity= 15 years and the

Face value of each bond =$1000)                                                                  10

Common stock:

-Shares outstanding (#5,000,000)                                                                  6

-Retained Earnings                                                                                         8

The yield to maturity of a new 15-year bond which is of similar risk as that of Air North's currently outstanding bond is 12%. Air North can issue this new bond at par of $1,000. Common stock can be issued to the existing shareholders at $18 per share which represents an 11.11% discount from the prevailing market price. Beta of the stock of the firm is 1.4 while the risk free rate and the expected rate of return on the market portfolio are 6% and 14% respectively. Earnings per share at the end of the year are anticipated to be $3. Air North's tax rate is 25%.

Find:

i)              The cost of capital to the firm

ii)            The cost of equity capital, taking into account three models of estimating cost of equity capital

iii)           The weight average cost of capital

Answer 1

cost of debt              
Yield to maturity of bond       12%      
after tax yield on bonds   YTM*(1- tax rate)   12*(1-.25)   9  
cost of capital using CAPM model   risk free rate+(market return-risk free rate)*beta   6+(14-6)*1.4   17.2  
cost of capital Using earning method   EPS/discounted issue price of share   3/18   16.67%  
cost of capital using market price   EPS/market price of share   3/20.25   14.81%  
market price   18/11.11%       20.25  
WACC              
source   value   weight   cost   weight*cost
debt   10   0.4166667   9   3.75
common stock   6   0.25   16.67   4.1675
retained earning   8   0.3333333   17.2   5.733333
total   24   WACC = sum of weight*cost       13.65
common stock- cost of capital of issued to existing members are taken into consideration as if the new shares are offered to them              
retained earning- for retained earning, required return using capm is used as cost of retained earnings