2]
Cost of debt
cost of debt = YTM * (1 - tax rate)
YTM is taken to be the average YTM of Company A, B and C's bonds.
Company A
YTM is calculated using RATE function in Excel with these inputs :
nper = 15*2 (15 years to maturity with 2 semiannual coupon payments each year)
pmt = 1000 * 10% / 2 (semiannual coupon payment = face value * annual coupon rate / 2. This is a positive figure as it is an inflow to the bondholder)
pv = -1140.72 (current bond price. This is a negative figure as it is an outflow to the buyer of the bond)
fv = 1000 (face value of the bond receivable on maturity. This is a positive figure as it is an inflow to the bondholder)
The RATE is calculated to be 4.17%. This is the semiannual YTM. To calculate the annual YTM, we multiply by 2. Annual YTM is 8.34%
Company B
YTM is calculated using RATE function in Excel with these inputs :
nper = 10*2 (10 years to maturity with 2 semiannual coupon payments each year)
pmt = 1000 * 8% / 2 (semiannual coupon payment = face value * annual coupon rate / 2. This is a positive figure as it is an inflow to the bondholder)
pv = -1200.30 (current bond price. This is a negative figure as it is an outflow to the buyer of the bond)
fv = 1000 (face value of the bond receivable on maturity. This is a positive figure as it is an inflow to the bondholder)
The RATE is calculated to be 2.69%. This is the semiannual YTM. To calculate the annual YTM, we multiply by 2. Annual YTM is 5.38%
Company C
YTM is calculated using RATE function in Excel with these inputs :
nper = 13*2 (13 years to maturity with 2 semiannual coupon payments each year)
pmt = 1000 * 12% / 2 (semiannual coupon payment = face value * annual coupon rate / 2. This is a positive figure as it is an inflow to the bondholder)
pv = -1350.54 (current bond price. This is a negative figure as it is an outflow to the buyer of the bond)
fv = 1000 (face value of the bond receivable on maturity. This is a positive figure as it is an inflow to the bondholder)
The RATE is calculated to be 3.84%. This is the semiannual YTM. To calculate the annual YTM, we multiply by 2. Annual YTM is 7.69%
Average YTM of 3 companies = (8.34% + 5.38% + 7.69%) / 3 = 7.14%
cost of debt = YTM * (1 - tax rate)
cost of debt = 7.14% * (1 - 20%)
cost of debt = 5.71%
Cost of preferred stock
cost of preferred stock = annual dividend / price per share
annual dividend = quarterly dividend * 4 = $1.5 * 4 = $6
cost of preferred stock = $6 / $110.14
cost of preferred stock = 5.45%
Cost of equity
cost of equity = (D1 / P0) + g,
where D1 = next year dividend
P0 = current share price
g = growth rate
g = ROE * retention ratio
retention ratio = 1 - (dividend per share / EPS)
dividend per share = dividends / shares outstanding = $90,000 / 100,000 = $0.90
retention ratio = 1 - ($0.90 / $3) = 70%
g = 4.5% * 70% = 3.15%
D1 = current dividend per share * (1 + g) = $0.90 * (1 + 3.15%) = $0.92835
cost of equity = (D1 / P0) + g
cost of equity = ($0.92835 / $143.50) + 0.0315
cost of equity = 3.80%
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