Question

Hollister & Hollister (H&H) is considering a new project. The project will require $522,000 for new fixed assets, $218,000 for additional inventory, and $39,000 for additional accounts receivable. Short-term debt (accounts payable/notes payable) is expected to increase by $165,000. The project has a 4-year life. The fixed assets will be depreciated under the three-year MACRS schedule to a zero book value over the life of the project. At the end of the project, the fixed assets can be sold for 20% of their original cost. The net working capital returns to its original level at the end of the project. The project is expected to generate annual sales of $975,000 with costs equal to 60% of revenues. H&H’s corporate tax rate is 34%.

H&H has 31,500 bonds outstanding with a 6.75% coupon rate, paid semi-annually, and 19 years left until maturity. These bonds are currently selling at 103% of par. They also have 2 million common shares outstanding that are currently selling at $11.50/share and have a beta of 1.3. The expected return on the market is 11% and the return on short-term U.S. T-bills is 2.5%.

What is the cost of equity for H&H? (Report answer in percentage terms and round to 2 decimal places. Do not round intermediate calculations).

What is the pre-tax cost of debt for H&H? (Report answer in percentage terms and round to 2 decimal places. Do not round intermediate calculations).

Answer 1

1.Cost of equity =risk free rate+(Beta*(market return-risk free rate))

US T bill rate=risk free rate=2.5%

Cost of equity=2.5%+(1.3*(11%-2.5%))=13.55%

2. pre tax cost of debt can be found using RATE function in EXCEL

=RATE(nper,pmt,pv,fv,type)

The bond payments are semi-annual

nper=number of periods=2*19=38

Coupon payment=67.5/2=33.75

pv=1030

fv=1000

=RATE(38,33.75,-1030,1000,0)

RATE=3.24%

Semi annual yeild=3.24%

Annual yield=2*3.24%=6.47%

Therefore, pre tax cost of debt=6.47%