1.Consider a company that has $100 million of debt outstanding that has a coupon

Question

1.Consider a company that has $100 million of debt outstanding that has a coupon rate of 5%, 10 years to maturity, and is quoted at $98. What is the after-tax cost of debt if the marginal tax rate is 40%? Assume semi-annual interest.

2. Suppose a company has preferred stock outstanding that has a dividend of $1.25 per share and a price of $20. What is the company’s cost of preferred equity?

3. If the risk-free rate is 3%, the expected market risk premium is 5%, and the company’s stock beta is 1.2, what is the company’s cost of equity?

4. Suppose Wright Corp has a capital structure composed of the following, in billions: • Debt $10 • Common equity $40 If the before-tax cost of debt is 9%, the required rate of return on equity is 15%, and the marginal tax rate is 30%, what is Wright’s weighted average cost of capital?

Explanation / Answer

1) $ 100 m debt coupon rate = 5% ( semi annual) 10 years to maturity current price =$ 98

so cost of debt =100m*5.06%(semi annual) =5.06m is before tax debt *(1-after tax dabt)

tax rate =40% 5.06(1-0.40) = 5.06*0.60=$ 3.036m

so after tax debt of the company=$ 3.036m

2) cost of preferred stock= Kp= DIV/P DIV=$ 1.25 Price =$ 20

1.25/20=0.0625 or 6.25%

3) cost of equity = E(R) = Rf+B(Rm-Rf)

E(R)= cost of equity Rf=risk free rate Rm = market risk premium B=beta

E(R)= 3%+1.2(5%-3%)

0.03+1.2(0.02) =0.03+0.024 =0.054 or 5.4%

4) WACC of Wright Corp=

weights = Debt =$ 10 Common Equity =$ 40 i.e 2:4

before tax cost of Debt =9% after tax cost of debt= 9(1-.30) 0.09*.70=0.063 or 6.3%

before tax cost of common equity =15% or 0.15 after tax cost =0.15(1-.30) = 0.15*.70=.105 or 10.5%

WACC Debt (Wd*Kd) + (Wcs*Kcs) 2*0.063+8*.105 =0.126+.84 = 0.966 or 9.66%

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