DuraMax Inc. manufactures car radios and reported $75 million in operating incom

Question

DuraMax Inc. manufactures car radios and reported $75 million in operating income last year on revenues of $ 1 billion last year. The firm is all equity funded and you have computed a beta for the firm of 0.80. You have estimate the optimal debt ratio for the firm to be 40% debt, and you expect the firm to have $20 million in interest expenses at that debt ratio. Using the interest coverage ratio table at the bottom of this page, estimate the cost of capital for DuraMax, at optimal debt ratio. The riskfree rate is 4% the tax rate is 40% and the equilty market risk premium is 4.82%

Explanation / Answer

Interest coverage ratio = Operating income / Interest expense

Operating income  75 million

Interest expense  20 million

Interest coverage ratio = 75 / 20 = 3.75

For an interest coverage ratio of 3.75

the default spread would be 2%

Re = rf + (rm – rf) *

Re=4%+(4.82%-4%)*0.80=0.04656

Cost of capital=0.04656(0.4)+(1-0.4)(0.4)

=0.018624+0.24=0.258624 or 25.86%

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