Question

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?

Answer 1

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%”