Question

Information on Janicek Power Co., is shown below. Assume the company’s tax rate is 40 percent. Debt: 10,400 9 percent coupon bonds outstanding, $1,000 par value, 21 years to maturity, selling for 94.5 percent of par; the bonds make semiannual payments. Common stock: 229,000 shares outstanding, selling for $84.90 per share; beta is 1.34. Preferred stock: 13,900 shares of 5.95 percent preferred stock outstanding, currently selling for $96.10 per share. Market: 7.2 percent market risk premium and 5 percent risk-free rate. Required: What is the company's cost of each form

Answer 1

(a)-After-Tax Cost of Debt

• The Yield to maturity (YTM) of the Bond is the discount rate at which the Bond’s price equals to the present value of the coupon payments plus the present value of the Face Value/Par Value
• The Yield to maturity of (YTM) of the Bond is the estimated annual rate of return expected by the bondholders for the bond assuming that the they hold the Bonds until it’s maturity period/date.
• The Yield to maturity of (YTM) of the Bond is calculated using financial calculator as follows (Normally, the YTM is calculated either using EXCEL Functions or by using Financial Calculator)

Variables	Financial Calculator Keys	Figure
Par Value/Face Value of the Bond [$1,000]	FV	1,000
Coupon Amount [$1,000 x 9.00% x ½]	PMT	45
Market Interest Rate or Yield to maturity on the Bond	1/Y	?
Maturity Period/Time to Maturity [42 Years x 2]	N	42
Bond Price/Current Market Price of the Bond [-$1,000 x 94.50%]	PV	-945

We need to set the above figures into the financial calculator to find out the Yield to Maturity of the Bond. After entering the above keys in the financial calculator, we get the semi-annual yield to maturity on the bond (1/Y) = 4.805%.

The semi-annual Yield to maturity = 4.805%.

Therefore, the annual Yield to Maturity of the Bond = 9.61% [4.805% x 2]

The firm’s after-tax cost of debt on the Bond is the after-tax Yield to maturity (YTM)

The After-tax cost of debt = Annual Yield to maturity on the bond x (1 – Tax Rate)

= 9.61% x (1 – 0.40)

= 9.61% x 0.60

= 5.77%

(b)-Cost of Preferred Stock

Cost of Preferred Stock = Preferred Dividend / Selling Price of the Share

= [$100 x 5.95%] / $96.10

= $5.95 / $96.10

= 0.0619 or

= 6.19%

(c)-The Cost of Equity

As per Capital Asset Pricing Model [CAPM], the cost of equity is calculated by using the following equation

Cost of equity = Risk-free Rate + [Beta x Market risk premium]

= 5.00% + [1.34 x 7.20%]

= 5.00% + 9.65%

= 14.65%