Question

You are trying to estimate the cost of capital for Miami corp, and have collected the following information:

The firm has $ 750 million in interest-bearing debt on its books, with a Market Value of $ 692.90 million. On the loan, the Company pays $ 40 million in annual interest expenses.

The weighted average maturity of the debt is 5 years. The bond rating for the firm is A-, and the default spread over the T.Bond rate is 2%.

There are 200 million shares outstanding, trading at $ 10 a share.

The unlevered beta for other shipping firms is 0.80.

The ten-year T.Bond rate is 5.2% and the market risk premium is 5.17%.

The marginal tax rate is 40%.

What is Miami corp's the cost of capital?

Answer 1

Solution:

levered beta=unlevered beta*[1+(1-tax)*Debt/equity]

=.80*[1+(1-.40)*$692.90/2000]

=.80*[1+(.60*.34645)]

=.80*1.20787

=.966296

=.97

Cost of equity(ke)=Risk free rate+beta(risk premium)

=5.20%+.97(5.17%)

=10.22%

Pre Tax Cost of Debt=Default spread+risk free rate

=2%+5.2%

=7.2%

After tax cost of debt(Kd)=7.2%(1-.40)

=4.32%

Weight of debt=Market value of debt/Market value of debt+Market value of equity

=$692.90 million/$692.90 million+$2000 million

=.26

Weight of Equity=1-Weight of debt

=1-.26

=.74

Cost of capital=kd*Weight of debt+ke*Weight of Equity

=4.32%*.26+10.22%*.74

=1.1232%+7.5628%

=8.686%

Miami corp's cost of capital is 8.69%