Question

A corporation's assets are currently valued at $150 million, and the face value of its debt is $60 million, which matures in 5 years. Volatility forecast models show that the variance 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?

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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