Question

Ohio Inc. has a beta of 1.6 and its debt-to-equity ratio is 0.8. The risk-free rate is 3.2% and the market risk premium is 9%. Although Ohio is a U.S. firm, it issued Swiss Franc (SF) denominated bond and converted SF to US dollar. The semi-annual interest payment is made in SF. The coupon rate is 8%, the price of the bond is SF1,040, the face value is SF1,000 and the bond matures in 10 years. The exchange rate is expected to move from SF0.9800/$ to SF0.9600/$. Ohio's tax rate is 40%.

a. What's Ohio's SF cost of debt?

b. What's your best estimate of Ohio's US dollar cost of debt?

c. What's Ohio's cost of equity?

d. What's Ohio's WACC?

Answer 1

a

Cost of debt:

Pv

Price of bond

1040

Nper

Number of semi annual period

20

Pmt

Semi annual interest payment

40

(1000*8%)/2

Fv

Payment at maturity

1000

RATE

Semi annual yield to maturity

3.71%

(Using RATE function of excelwith Nper=20,Pmt=40,Pv=-1040,Fv=1000)

Excel Command: RATE(20,40,-1040,1000)

Annual SF cost of debt =3.71*2=

7.43%

b

Exchange Rate moves from SF0.9800 to SF0.9600

Rate of increase in dollar cost=

As per old exchange rate 0.9800 SF=

$1

As per New exchange rate 0.9800 SF=

$1.0208

(0.9800/0.9600)

Rate of increase in dollar cost=

0.0208

Rate of increase in dollar cost=

2.08%

Estimated US dollar cost of debt=((1+0.0743)*(1+0.0208))-1

Estimated US dollar cost of debt=

0.096645

Estimated US dollar cost of debt=

9.66%

c

Cost of Equity

Required Return =Rf+Beta*Rp

Rf=Risk Free rate=3.2%

Beta=1.6

Rp=Market Risk Premium=9%

Required Return =3.2+1.6*9

17.60%

d

Weighted average cost of capital (WACC)=Weight of Debt*Cost of debt+Weight of Equity*Cost of Equity

D/E=0.8

D=0.8E

Total capital =0.8E+E=1.8E

Weight

Cost

Weight*Cost

Weight of debt (0.8E/1.8E)

0.444444

7.43%

0.033022

Weight of Equity (E/1.8E)

0.555556

17.60%

0.097778

SUM

0.1308

Weighted average cost of capital (WACC)

0.1308

Weighted average cost of capital (WACC)

13.08%