Question

You found out that the corporation assets are currently valued at $150, and that the face value of its debt is $60, which matures in 5 years. Volatility forecast models show that the varance of traded equity of the corporation is 0.16. Assuming that the risk-free rate is 2% and market risk premium of 6%,and the corporation has a CAPM beta of 1.6. what is the cost of debt? (note all $ numbers are in millions.)   

Answer 1

• Step 1 Calculation of cost of Equity

  Cost of Equity (As per CAPM) = Risk free Rate + Beta x Market Risk Premium

  Cost of Equity (As per CAPM) = 2% + 1.60 x 6%

  Cost of Equity = 11.60%

  Step 2 Calculation of Weight of Equity and Debt

  Total Asset Value = $150 million

  Debt = $60 million

  Equity =$150 milllion -$ 60 million = $90 million

  Weight of Debt = $60/$150 =40%

  Weight of Equity = $90/$150 =60%

  Step 3 Calculation of Cost of Debt

  WACC = Weight of equity x Cost of equity + Weight of Debt x cost of debt

  16% = .60 x 11.60% + .40 x cost of debt

  16% =6.96% + .40 Cost of debt

  (16% -6.96% )/0.40 = cost of debt

  Cost of Debt = 22.60%

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