Question

Your firm is considering a new investment proposal and would like to calculate its weighted average cost of capital. To help in​ this, compute the cost of capital for the firm for the​ following:

1. A bond that has a $1,000 par value (face value) and a contract or coupon interest rate of 11.2% that is paid semiannually. The bond is currently selling for a price of $1127 and will mature in 10 years. The firm;s tax rate is 34%. The after-tax cost of debt from the firm is _________%. (Round to two decimal places).

2. If the firm's bonds are not frequently traded, how would you go about determining a cost of debt for this company? (Select the best answer)

a. It is standard practice to estimate the cost of debt using the average coupon rate on a portfolio of bonds with a similar credit rating and maturity as the​ firm's outstanding debt.

b. It is standard practice to estimate the cost of debt using the yield to maturity on a portfolio of bonds with a similar credit rating and maturity as the​ firm's outstanding debt.

c. It is standard practice to estimate the cost of debt using the yield to maturity on a treasuty bond of the same maturity.

d. It is standard practice to estimate the cost of debt using the​ bond's coupon rate and adjust it for inflation.

3. A new common stock issue that paid $1.79 dividend last year. The par value of the stock is $16, and the firm's dividends per share have grown at a rate of 8.3% per year. The growth rate is expected to continue onto the foreseeable future. The price of this stock is now $27.89. The cost of common equity for the firm is _______%.(Round to two decimal places)

4. A preferred stock paying a 10.8% dividend on a $130 par value. The preferred shares are currently selling for $151.56. The cost of preferred stock for the firm is____________%.(Round to two decimal places)

5. A bond selling to yield 13.2% for the purchaser of the bond. The borrowing firm faces a tax rate of 34%. The after-tax cost of debt for the firm is _________%. (Round to two decimal places)

Answer 1

1. FV = 1,000

Semi Annual Payment = 11.2% * 1,000/2 = 56

N = 10 * 2 = 20

PV = 1,127

Using Financial calculator:

I = 4.61%

YTM = 4.61% * 2

YTM = 9.23%

After tax cost of debt = 9.23% * (1 - 34%)

After tax cost of debt = 6.09%

2. Option B is correct

It is standard practice to estimate the cost of debt using the yield to maturity on a portfolio of bonds with a similar credit rating and maturity as the firm's outstanding debt

3. D0 = 1.79

P0 = 27.89

g = 8.3%

Cost of common equity = D1/ P0 + Growth rate

Cost of common equity = 1.79 * (1 + 8.3%)/ 27.89 + 8.3%

Cost of common equity = 1.93857/ 27.89 + 8.3%

Cost of common equity = 15.25%

4. Dividend = 10.8% * 130

Dividend = 14.04

Cost of preferred stock = 14.04/ 151.56

Cost of preferred stock = 9.26%

5. Yield = 13.2%

Tax = 34%

After tax cost of debt = 13.2% * (1 - 34%)

After tax cost of debt = 8.71%