Question

The Parker Group, a leading producer of custom home electronic accessories, has hired you to estimate the firm's weighted average cost of capital. The balance sheet and some other information are provided below. Assets The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00. The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. The firm's tax rate is 40%. What is the best estimate of the after-tax cost of debt? Question 8 options:

a) 5.03%

b) 5.14%

c) 5.40%

d) 5.67%

Answer 1

Answer: b) 5.14%

There are a total of 40 periods since coupon payments are half yearly, Following figures show cash flows and present value of cash flows for these 40 years.

PV= $875

Coupon 1 = Coupon 2 = Coupon 3 = ............= Coupon 40 = 1000*7.25%/2 = $36.25

FV = $1000

Substituting these values in the above equation and solving for r, we get r= 4.28%. This is equal to pre-tax cost of debt.

Goal Seek function can be used in Excel to solve for r.

4.28% is the half yearly rate, annual rate = 4.28%*2 = 8.57%

After-tax annual cost of debt = 8.57% * (1-40%) = 5.14%

To calculate the PV, PV function in Excel can also be used.

PV(4.28%,40,36.25,1000). r can be substituted as a guess value, say 5%, initially. Then Foal Seek can be used to get a PV of $875