Question

Geralt Technologies is considering a major expansion program that has been proposed by the company’s information technology group. Before proceeding with the expansion, the company need to develop an estimate of its cost of capital. Assume that you are an assistant to Henry Cavill, the financial vice-president. Your first task is to estimate Geralt’s cost of capital. Henry has provided you with the following data, which he believes may be relevant to your task:

(i) The firm’s tax rate is 40%.

(ii) The current market price of Geralt’s $1,000 par value, 12 percent coupon, semi-annual payment, non-callable bonds with 15 years remaining to maturity is $1,153.72. Geralt does not use short-term interest-bearing debt on a permanent basis.

(iii) The current price of the firm’s 10%, $100 par value, annual dividend, perpetual preferred stock is $111.10. The company would incur a issuing cost of 6%.

(iv) Geralt’s common stock is currently selling at $50 per share. Its last dividend was $4.19, and dividends are expected to grow at a constant rate of 5% in the foreseeable future. Geralt’s beta is 1.2, the yield on T-bonds is 7%, and the market risk premium is estimated to be 6%. For the bond-yield-plus-risk-premium approach, the firm uses a 4% point risk premium.

(v) Geralt’s target capital structure is 30% long-term debt, 10% preferred stock, and 60% common equity.

To structure the task somewhat, Henry has asked you to answer the following questions:

1. a) What is the market interest rate on Geralt’s debt? What is its component After-tax cost of debt?

b) What is the firm’s cost of preferred stock?

Answer 1

(1)(a)-The market interest rate on Geralt’s 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 12.00% x ½]	PMT	60
Market Interest Rate or Yield to maturity on the Bond	1/Y	?
Maturity Period/Time to Maturity [15 Years x 2]	N	30
Bond Price/Current Market Price of the Bond [-$1,153.72]	PV	-1,153.72

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) = 5.00%.

The semi-annual Yield to maturity = 5.00%.

Therefore, the annual Yield to Maturity of the Bond = 10.00% [5.00% x 2]

“Hence, the market interest rate on Geralt’s debt will be 10.00%”

(1)(a)-The After-tax cost of debt

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)

= 10.00% x (1 – 0.40)

= 10.00% x 0.60

= 6.00%

“Hence, the After-tax cost of debt will be 6.00%”

(2)-The firm’s cost of preferred stock

The firm’s cost of preferred stock = Annual preferred dividend / [Market price x (1 – Flotation costs)]

= [$100 x 10.00%] / [$111.10 x (1 – 0.06)]

= $10.00 / [$111.10 x 0.94]

= $10.00 / 104.43

= 0.0958 or

= 9.58%