Question

The financial data for a corporation is provided to calculate all the following question. Most recent annual common dividend $4.00 Today’s common stock price $50.00 U.S. Treasury 10y annual rate 3 percent Market risk premium 5 percent Equity Risk Premium on Bond Yield 10 percent Number of common shares outstanding 2.5 million Today’s preferred stock price $100.00 Fixed preferred dividend $8.00 Constant growth rate 6 percent Beta β 2.0 Floatation costs for Preferred and common stock issuance 7 percent Market price of the bond $1,100.00 Annual coupon on the bond $70.00 Years to bond maturity 5 years Par value bond $1,000 Number of preferred shares outstanding 200,000 Number of bonds outstanding 200,000 Previous year annual Income Statement (amounts in millions) Sales $200,000 Variable operating costs (60% of sales) (120,000) Gross profit 80,000 Fixed operating costs (40,000) Net operating income (EBIT) 40,000 Interest expense (10,000) Taxable income 30,000 Taxes (12,000) Net income $18,000 Company can raise more debt by selling 50,000 new bonds at the same rate (interest) and receiving the market price of the bond i.e. $1,100. The outstanding 200,000 bonds and the additional 50,000 is the maximum the company can raise in debt. After this amount, the average after tax cost of debt will be increased by 1 percent. In the upcoming annual financial results, the company expects to generate 75 million dollars in retained earnings for the capital budgeting projects. Any requirement of funds beyond this would require issuance of new stock at the market price of $50 per share while maintaining the existing capital structure. Company has following projects for consideration Projects Investment Expected MIRR A $50 million 13 percent B $60 million 10 percent C $100 million 8 percent D $10 million 7.5 percent

Refer to the date set:  The cost of debt at the current market price is:

	a.	4.71 percent
	b.	7 percent
	c.	70 percent
	d.	$70

Answer 1

The cost of debt at the current market price

• The cost of debt at the current market price is the Yield to maturity of (YTM) of the Bond
• The Yield to maturity of (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 [$70]	PMT	70
Market Interest Rate or Yield to maturity on the Bond	1/Y	?
Maturity Period/Time to Maturity [5 Years]	N	5
Current price of the Bond [-$1,100]	PV	-1,100

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 annual yield to maturity (YTM) on the bond = 4.71%.

Therefore, the cost of debt at the current market price will be (a). 4.71 percent