Question

A firm has determined its cost of each source of capital and optimal capital structure, which is composed of the following sources and target market value proportions. To get the cost of equity, the following is provided, Risk free rate of return is 5%, the stock has a Beta of 1.25x and the Market Return is expected to be 11.5%. The firms existing debt has a 8.5% coupon 9 year maturity and trades at 93.75%. The firm is in the 40% tax bracket.

Source of capital / Target Market Proportions / Pre-Tax Cost

Long Term Debt / 40% / ?

Preferred Stock / 10% / 11%

Common Stock Equity / 50% / ?

Answer 1

Answer :

Source of capital / Target Market Proportions / Pre-Tax Cost

Long Term Debt / 40% / 9.55%

Preferred Stock / 10% / 11%

Common Stock Equity / 50% / 13.13%

Working:

Pre-Tax cost of debt:

Firms existing debt has a 8.5% coupon

Semiannual coupon = 1000 * 8.5%/2 = $42.50

Time to maturity = 9 * 2 = 18 semiannual periods

Price = 1000 * 93.75% = $937.50

Semiannual YTM = RATE (nper, pmt, pv, fv, type) = RATE (18, 42.50, -937.50, 1000, 0)

= 4.775%

Pre-Tax cost of debt = 4.775% * 2 = 9.55%

Cost of Equity:

Cost of equity = Risk free rate + beta * (Market rate of return - Risk free rate)

= 5% + 1.25 * (11.5% - 5%)

= 13.125%

= 13.13%