As Chief Economic Adviser at BigOil Company, you are also the company’s Chief Fi

Question

As Chief Economic Adviser at BigOil Company, you are also the company’s Chief Financial Officer. Your company has launched an ambitious capital investment program, and the Board of Directors has assigned to you the task of estimating the company’s cost of capital. You take this assignment seriously and decided to do the work yourself. Suppose that one of your assistants has collected the following data for BigOil Company.

The company’s capital structure (mix of debt and equity) is composed of:

Debt (D) = $385.7M and Common stock (E) = $1,200.0M

The cost of debt can be estimated using the cost of bonds (the principal component in the company’s debt), which has the following characteristics:

Face Value = $1,000; Coupon rate = 6%, paid annually; time to maturity = 10 years; the bonds currently trade for $807.47; BigOil’s corporate tax rate (Tc) = 35%.

The cost of equity can be estimated using CAPM, assuming the following data:

Return on the risk-free security (e.g., 10-year US government note) = 3%; Return on the market index (e.g., S&P500) = 11.2%; BigOil’s Beta = 1.1.

1.What is the amount of equity risk premium for BigOil’s stock? What is the market equity risk premium?

Explanation / Answer

Market risk premium=market return-risk free rate=11.2%-3%=8.2%

Equity risk premium=return on stock-risk free=risk free+beta*market risk premium-risk free=beta*market risk premium=1.1*8.2=9.02%

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