Question

The company XYZ has a stock price of $10 and 100,000 outstanding shares. The stock beta is 1.5. The market value of XYZ’s debt is $600,000. The debt consists of bonds with an annual yield to maturity (YTM) of 7%. The probability of default is 5% and in case of default, the expected loss rate is 40%. The corporate tax rate is 20%. In addition, assume that the expected market risk premium is 5% and that the risk-free interest rate is 0.5% per year.

Question: Compute the cost of equity and cost of debt?

Answer 1

1) Cost of Equity and debt is computed as follows

Cost of Equity = 0.5% + (5%)*1.5

= 0.5% +7.5%

Cost of Equity = 8%

2) Cost of Debt is (1- effective tax rate) * interest rate

= (1 - 40%) * 7%

= 60%*7%

Cost of Debt= 4.2%