Question

Please solve the following problem using Financial Formulas Only. Please No Excel.

Roberto Inc. is a manufacturing company. The company has always followed their ideal capital structure which the management insists is 40% debt and 60% equity capital. The company can issue bonds for 9% coupon rate with 22 years to maturity. The interest is paid semi-annually. The bonds can be issued with a price of $835.42 today. Roberto's marginal tax rate is 40%. For cost of equity, the company uses the CAPM based on SML. The risk-free rate in the market is 8% and the market rate of return is 14%. The company has a beta of 1.1. Roberto is experiencing a highly abnormal growth rate of 30%. This growth rate is expected to continue for four years. After year four, the growth rate is expected to return to a normal 8% and remain constant afterwards for the foreseeable future. Roberto just paid a dividend of $1.15. Furthermore, Roberto is evaluating several projects to invest in. The top project that is being considered will cost $1,000,000 and promises to pay $500,000 in year one, $400,000 in year two, $300,000 in year three and $100,000 in year four. This project will cease to exist with no salvage value at end of year four. So, the cash flow would look like the following: Year CF ($ in 000's) -1,000 (Initial Outlay) on m 500 400 300 100 Based on the information provided above, answer the following questions:

Answer 1

To find the cost of debt, we need to put the following values in the financial calculator:

N = 22*2 = 44;

PV = -835.42;

PMT = (9%/2)*1000 = 45;

FV = 1000;

Press CPT, then I/Y, which gives us 5.50

So, Periodic Rate = 5.50%

Before-tax cost of debt = Periodic Rate * No. of compounding periods in a year

= 5.50% * 2 = 11%

After-tax cost of debt = Before-tax cost of debt * (1 - t) = 11% * (1 - 0.40) = 6.60%

Hence, Option "a" is correct.