Question

A firm has issued $20 million in long-term bonds that now have 10 years remaining until

maturity. The bonds carry an 8% annual coupon but are selling in the market for $877.10.

The firm also has $45 million in market value of common stock. For cost of capital

purposes,

1. What portion of the firm is debt financed and what is the after-tax cost of debt,

if the tax rate is 35%?

2. In computing the cost of capital, which sources of capital should be considered?

Answer 1

Given

Long Term Bonds = 20 million dollars

Tenure 10 Years

Coupon = 8% per anum

Market Price = 877.10 dollars

Equity = 45 million dollars

1) While considering weights we have to consider the market values of the capital

Market Value of debt = (20 millions/1000 )* 877.10 = 17,542,000 dollars

Sources	Market Value	Weights
Debt	17542000	0.280484
Equity	45000000	0.719516
Total	62542000	1

The portion at which debt is financed is approximately 28%

After tax cost of debt = Coupon Rate *(1-tax rate) = 8%*(1-35%) = 8%*0.65 = 5.2%

2) In computing Cost of Capital we have to consider following sources of capital

a) Debts and loans

b) Preference Share Capital and

c) Equity Share Capital.