Question

Question 6

A. Gigi recently inherited some bonds (face value $100,000) from her father, and soon thereafter she became engaged to Adrian, a Bond Business School marketing graduate. Ralf wants Gigi to cash in the bonds so the two of them can use the money to “live like royalty” for two years in Monte Carlo. The 2 percent annual coupon bonds mature on December 31, 2037, and it is now January 1, 2018. Interest on these bonds is paid annually on December 31 of each year, and new annual coupon bonds with similar risk and maturity are currently yielding 7 percent. If Gigi sells her bonds now and puts the proceeds into an managed fund that pays 5 percent compounded annually, what would be the largest equal annual amounts she could withdraw for two years, beginning today (that is, two payments, the first payment today and the second payment one year from today)?

B. “Cost of Capital always depends on the risk of the project being evaluated. Therefore company costs of capital are useless”. Is that correct? Evaluate the statement.

Answer 1

Step 1:

Calculate PV of the bonds

V_d = $2000 [1-(1/(1..07)^20/0.07] + $100,000/(1+0.07)^20 = $33,224.7

Step 2:

Calculate the equal payments of the annuity due.

$33,224.7= PMT {[1-1(1/1.05^2)]/0.05} X 1.05

PMT=$32,509.5

b). From the point of view of a company, cost-of-capital is the rate of return that it has to offer to compensate its investors (shareholders and bondholders) for the capital they provide . Following from the risk-return relationship explained in the previous section, the cost-of-capital of a business firm depends on the riskiness of the capital that is invested. Due to an increasing global mobility and flexibility of capital, companies need to ensure that they offer the required return, since they risk losing their investors otherwise. This trend is reinforced by an increased professionalism of capital market actors. A company raises capital from various funding sources. The main sources are equity and debt, which both need to be remunerated at their own cost-of-capital