Your firm is considering a new investment proposal and would like to calculate t

Question

Your firm is considering a new investment proposal and would like to calculate the 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 12.3% that is paid semiannually. The bond is currently selling for a price of $1121 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 using the yield to maturity 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 using the average coupon rate on a portfolio of bonds with 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 $1.77 dividend last year. The par value of the stock is $14, and the firm's dividends per share have grown at a rate of 7.1% per year. The growth rate is expected to continue onto the foreseeable future. The price of this stock is now 27.92. The cost of common equity for the firm is _______%.(Round to two decimal places)

4. A preferred stock paying a 10.6% dividend on a $130 par value. The preferred shares are currently selling for $146.89. The cost of preferred stock for the firm is____________%.(Round to two decimal places)

5. A bond selling to yield 12.1% 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)

Explanation / Answer

Part 1)

The cost of debt can be calculated with the Rate function/formula of EXCEL/Financial Calculator. The formula/function for Rate is Rate(Nper,PMT,-PV,FV) where Nper = Period, PMT = Interest Payment, PV = Current Price of Bonds and FV = Face Value of Bonds.

___________

Here, Nper = 10*2 = 20, PMT = 1,000*12.3%*1/2 = $61.50, PV = $1,121 and FV = $1,000 [we use 2 since the bond is semi-annual]

Pre-Tax Cost of Debt = Rate(20,61.50,-1121,1000)*2 = 10.33%

___________

After-Tax Cost of Debt = Pre-Tax Cost of Debt*(1-Tax Rate) = 10.33%*(1-34%) = 6.82%

__________________

Part 2)

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

__________

Explanation:

Since, most of the bonds are not traded in the public market, the cost of debt is frequently estimated with the use of information for similar types of bonds with similar credit rating and maturity. These bonds act as reference points for determining the cost of bonds.

__________________

Part 3)

The cost of common equity can be calculated with the use of following formula:

Cost of Common Equity = D0*(1+Growth Rate)/Current Stock Price + Growth Rate where D0 is the dividend paid last year

__________

Using the information provided in the question, we get,

Cost of Common Equity = 1.77*(1+7.1%)/27.92 + 7.1% = 13.89%

__________________

Part 4)

The cost of preferred stock can be calculated with the use of following formula:

Cost of Preferred Stock = Annual Dividend/Current Stock Price*100 where Annual Dividend = Dividend Percentage*Par Value

__________

Using the information provided in the question, we get,

Cost of Preferred Stock = (10.6%*130)/146.89*100 = 9.38%

__________________

Part 5)

The after-tax cost of debt can be calculated with the use of following formula:

After-Tax Cost of Debt = Yield*(1-Tax Rate)

__________

Using the information provided in the question, we get,

After-Tax Cost of Debt = 12.1%*(1-34%) = 7.99%

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