Question

23. Zubee, Inc. is trying to estimate its current cost of capital. Zubee believes that the appropriate weight of debt is 80% and the appropriate weight of equity is 20%. Zubee has a tax rate of 30%. Zubee's bonds currently trade in the market for a price of $8,785. These $10,000 par value bonds have a coupon rate of 7.8% (semi-annual coupon payments) and they mature in 30 years.  The beta of Zubee is 1.532. The risk-free rate is 5% and the market return is 10%. Answer Q1 to Q4

Q1) What is Zubee's cost of debt (YTM of debt)?

a)9.12%

b)8.97%

c)8.75%

d)4.487%

Q2) What is Zubee's cost of equity?

a)12.66%

b)15.39%

c)16.84%

d)19.77%

Q3) What is Zubee's cost of capital (WACC)?

a)4.32%

b)7.56%

c)6.99%

d)8.73%

Q4) What is the fair value of Zubee if its projected cash flow is as follows

Year 1: 500

Year 2: 650

Starting from year 3, the CF is growing at 2.15% forever.

a)15274.62

b)11636.96

c)13787.93

d)9340.57

Answer 1

1

Cost of debt

K = Nx2

Bond Price =∑ [(Semi Annual Coupon)/(1 + YTM/2)^k]     +   Par value/(1 + YTM/2)^Nx2

k=1

K =30x2

8785 =∑ [(7.8*10000/200)/(1 + YTM/200)^k]     +   10000/(1 + YTM/200)^30x2

k=1

YTM = 8.97

2

As per CAPM

Cost of equity = risk-free rate + beta * (expected return on the market - risk-free rate)

Cost of equity% = 5 + 1.532 * (10 - 5)

Cost of equity% = 12.66

3

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 8.975*(1-0.3)

= 6.2825

WACC=after tax cost of debt*W(D)+cost of equity*W(E)

WACC=6.28*0.8+12.66*0.2

WACC =7.56%

4

	WACC=	7.56%
Year	Previous year FCF	FCF growth rate	FCF current year	Horizon value	Total Value	Discount factor	Discounted value
1	0	0.00%	500		500	1.0756	464.8568
2	500	0.00%	650	12273.105	12923.105	1.15691536	11170.31154
	Long term growth rate (given)=	2.15%			Value of Enterprise =	Sum of discounted value =	11636.96

Where
Total value = FCF + horizon value (only for last year)
Horizon value = FCF current year 2 *(1+long term growth rate)/( WACC-long term growth rate)
Discount factor=(1+ WACC)^corresponding period
Discounted value=total value/discount factor