Question

Firm A plans to finance the project from the following sources:

**Debt:**

Outstanding bonds of firms of similar risk and maturity as Firm B have an annual coupon of 5.75 percent, paid semiannually, mature in 15 years, and currently sell for $855. The firm’s marginal tax rate is 21%.

**Common Stock:**

The most recent dividend on the common shares, D0 was $1.20 and that dividend is expected to grow at 2 percent per year. The expected issue price is $15.00.

1.) If Firm A intends to issue 15 year bonds to fund this project, what is the best estimate of the firm's borrowing cost? Answer should be in decimals.

2.) Use the dividend discount model discussed in the PP slides to estimate the cost of common stock (the required rate of return on the stock). Answer should be in decimals (0.001).

3.) The following information reflects market values of Firm A’s capital structure.

- Assets $54,380
- Debt $20,664

_____________ percent of the firm is financed with equity. Answer should be a number (33).

4.) Assuming Firm A wants to maintain is current capital structure, estimate the project's weighted average cost of capital.

Answer #1

1. cost of debt has to be found using RATE function in EXCEL

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

Please remember that payments are semi-annual

nper=2*15=30 periods

pmt=semi-annual coupon=(coupon rate*face value)/2=(5.75%*1000)/2=57.5/2=28.75

pv=855

fv=fave value=1000

=RATE(30,28.75,-855,1000,0)=3.68%

Annual cost=2*3.68%=7.36%

After tax cost of debt (borrowing cost)=7.36%*(1-tax rate)=7.36%*(1-21%)=5.82% (0.0582)

2. Required rate of return=(D1/Sahre price)+growth rate

D1=D0*(1+growth rate)=1.2*(1+2%)=1.224

Required rate of return=(1.224/15)+2%=10.16%

3. Equity=Assets-Debt=54,380-20,664=33716

Percenatge of equity=33716/54,380=62%

Therefore Peracentage of debt=(1-62%)=38%

4. weighted average cost of capital=(weight of debt*after tax cost of debt)+(weight of equity*required rate)

=(38%*5.82%)+(62%*10.16%)

=8.51%

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