Question

The company you work for wants you to estimate the company's WACC; but before you do so, you need to estimate the cost of debt and equity. You have obtained the following information (1) the firms non-callable bonds mature in 20 years, have an 8.00% annual coupon, a par value of $1,000 and a market price of $1,225.00. (2) The company's tax rate is 40%. (3) The risk-free rate is 4.50%, the market risk premium is 5.50%, and the stocks beta is 1.20. (4) The target capital structure consists of 35% debt and the balance common equity. The firm uses the CAPM to estimate the cost of equity, and it does not expect to issue any new common stock. Calculate the company's component cost of debt. Please include formulas and do not use excel.

Answer 1

Information provided:

Risk free arte= 4.50%

Market risk premium= 5.50%

Beta= 1.20

Par value= future value= $1,000

Current price= present value= $1,225

Time= 20 years

Coupon rate= 8%

Coupon payment= 0.08*1,000= $80

The cost of equity is calculated using the Capital Asset Pricing Model (CAPM) which is calculated using the formula below:

Ke=Rf+[E(Rm)-Rf]

Where:

Rf=risk-free rate of

Rm=expected rate of return on the market.

Rm- Rf= Market risk premium

= stock’s beta

Ke= 4.50% + 1.20*5.50%

     = 4.50% + 6.60%

     = 11.10%.

Therefore, the cost of equity is 11.10%.

The cost of debt is calculated by computing the yield to maturity.

Enter the below in a financial calculator to compute the yield to maturity:

FV= 1,000

PV= 1,225

PMT= 80

N= 20

Press the CPT key and I/Y to compute the yield to maturity.

The value obtained is 6.03.

Therefore, the cost of debt is 6.03%.

In case of any query, kindly comment on the solution.