You have been provided the information on the cost of debt and cost of capital t
ID: 2638652 • Letter: Y
Question
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 cost of debt at 18%. The long term treasury bond rate is 7%. Assume the market risk premium is 6.3%.
Debt Ratio
10%
18%
$ Debt
$ 1,500
EBIT
$ 1,000
Interest Expenses
$120
Interest Coverage Ratio
6.56
Bond Rating
A
Interest Rate
6%
Tax Rate
40%
Beta
1.55
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%
Debt Ratio
10%
18%
$ Debt
$ 1,500
EBIT
$ 1,000
Interest Expenses
$120
Interest Coverage Ratio
6.56
Bond Rating
A
Interest Rate
6%
Tax Rate
40%
Beta
1.55
Explanation / Answer
Existing Revised Debt Ratio 10% 18% Debt $1,500.00 $2,700.00 Interest $120.00 $216.00 Interest Rate 6.00% 6.00% Tax Rate 40% 40% Cost of Debt(after tax) 3.60% 3.60% Beta 1.55 1.55 Risk free rate 8.50% 8.50% Risk Premium 6.30% 6.30% Cost of Equity 18.27% 18.27%
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