debt Ratio 10% 19% $ Debt $ 1,500 EBIT $ 1,000 Interest Expenses $120 Interest C
ID: 2638648 • Letter: D
Question
debt Ratio
10%
19%
$ Debt
$ 1,500
EBIT
$ 1,000
Interest Expenses
$120
Interest Coverage Ratio
5.32
Bond Rating
A
Interest Rate
5%
Tax Rate
40%
Beta
1.35
The interest coverage ratios, ratings and spreads are as follows:
Coverage Ratio
Rating
Spread over Treasury
> 10
AAA
0.30%
7 -10
AA
1.00%
5 - 7
A
1.50%
3 - 5
BBB
2.00%
2- 3
BB
2.50%
1.25 - 2
B
3.00%
0.75 - 1.25
CCC
5.00%
0.50 - 0.75
CC
6.50%
0.25 - 0.50
C
8.00%
< 0.25
D
10.00%
You have been provided the information on the cost of debt and cost of capital that a company will have at a 10% debt ratio, and asked to estimate the weighed after tax cost of debt at 19%. The long term treasury bond rate is 6%. Assume the market risk premium is 6.9%.
debt Ratio
10%
19%
$ Debt
$ 1,500
EBIT
$ 1,000
Interest Expenses
$120
Interest Coverage Ratio
5.32
Bond Rating
A
Interest Rate
5%
Tax Rate
40%
Beta
1.35
Explanation / Answer
Interest covergae = EBIT / Interest
Existing: 5.32 = EBIT / 120
EBIT = 5.32 * 120 = 638.40
Revised Interest cost at 19% debt level = 120 * 19 / 10 = 228
Revised interest coverage = 638.40 / 228 = 2.80
Therefore spread over T bond = 2.50% (Adopted from table given in the question)
Coupon rate on bond = 6% + 2.5% = 8.5%
Cost of debt = Rate * (1-T)
= 8.50% * (1-.40)
= 5.10%
Weighed after tax cost of debt at 19%:
= 5.10% * 0.19
= 0.97%
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