Question

# 1. The firm's tax rate is 40%. 2. The current price of Legacy’s 10% coupon, noncallable...

1. The firm's tax rate is 40%. 2. The current price of Legacy’s 10% coupon, noncallable bonds with 10 years remaining to maturity is \$1,100.00. Legacy does not use short-term interest-bearing debt on a permanent basis. 3. The current price of the firm’s 8%, \$100 par value, perpetual preferred stock is \$114.00. 4. Legacy’s common stock is currently selling at \$45 per share. Its last dividend (D0) was \$3.00, and dividends are expected to grow at a constant rate of 6.0% in the foreseeable future. Legacy’s beta is 1.1; the yield on T-bonds is 6.0%; and the market risk premium is estimated to be 5.5%. For the over-own-bond-yield-plus-judgmental-risk-premium approach, the firm uses a 4.0% judgmental risk premium. 5. Legacy’s capital structure is 40% long-term debt, 10% preferred stock, and 50% common equity.

What is the cost of equity based on the bond-yield-plus-judgmental-risk-premium method?

The cost of equity based on the bond-yield-plus-judgmental-risk-premium method

Yield to Maturity [YTM] of the Bond

Yield to Maturity [YTM] = Coupon Amount + [(Par Value – Bond Price) / Maturity Years] / [(Par Value + Bond Price)/2]

Par Value = \$1,000

Annual Coupon Amount = \$100 [\$1,000 x 10%]

Bond Price = \$1,100

Maturity Years = 10 Years

Therefore, Yield to Maturity [YTM] = Coupon Amount + [(Par Value – Bond Price) / Maturity Years] / [(Par Value + Bond Price)/2]

= [\$100 + {(\$1,000 – \$1,100) / 10 Years)] / [(\$1,000 + \$1,100) / 2}]

= [(\$100 - \$10) / \$1,050]

= 0.0848

= 8.48%

Therefore, the cost of Equity = Bonds Yield + Judgmental Risk Premium

= 8.48% + 4%

= 12.48%

“Hence, the cost of equity based on the bond-yield-plus-judgmental-risk-premium method would be 12.48%”