Question

Running Shoes, Inc. has 2 million shares of stock outstanding. The stock currently sells for $12.50 per share. The firm’s debt is publicly traded and was recently quoted at 90% of face value. Ir has a total face value of $10million, matures in 10 years and it is currently priced to yield 8%. The risk free rate is 2% and the market return is 8%. You've estimated that the firm has beta of 1.20. The corporate tax rate is 40%.

What is the after tax cost of debt?

What is the weight of debt?

Answer 1

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 8*(1-0.4)

= 4.8

MV of equity=Price of equity*number of shares outstanding

MV of equity=12.5*2000000

=25000000

MV of Bond=Par value*bonds outstanding*%age of par

MV of Bond=1000*10000*0.9

=9000000

MV of firm = MV of Equity + MV of Bond

=25000000+9000000

=34000000

Weight of debt = MV of Bond/MV of firm

Weight of debt = 9000000/34000000

W(D)=0.2647