Question

# You are trying to estimate the cost of capital for Miami corp, and have collected the...

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?

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%

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