Question

Assume that you have been hired as a consultant by CGT, a major producer of chemicals and plastics, including plastic grocery bags, styrofoam cups, and fertilizers, to estimate the firm's weighted average cost of capital. The balance sheet and some other information are provided below.

Assets

Current assets $38,000,000

Net plant, property, and equipment $101,000,000

Total assets $139,000,000

Liabilities and Equity

Accounts payable $10,000,000

Accruals $9,000,000

Current liabilities $19,000,000

Long-term debt (40,000 bonds, $1,000 par value) $40,000,000

Total liabilities $59,000,000

Common stock (10,000,000 shares) $30,000,000

Retained earnings $50,000,000

Total shareholders' equity $80,000,000

Total liabilities and shareholders' equity $139,000,000

The stock is currently selling for $17.75 per share, and its noncallable $3,319.97 par value, 20-year, 1.70% bonds with semiannual payments are selling for $881.00. The beta is 1.29, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. The firm's tax rate is 40%. Refer to Exhibit 10.1. What is the best estimate of the after-tax cost of debt?

5.62%

6.07%

6.39%

6.77%

7.11%

Answer 1

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

N = 20*2 = 40;

PV = -881;

PMT = (1.70%/2)*3,319.97 = 28.22;

FV = 3,319.97;

Press CPT, then I/Y, which gives us 5.32

Periodic Rate = 5.32%

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

= 5.32% * 2 = 10.64%

After-tax cost of debt = Before-tax cost of debt * (1 - t) = 10.64% * (1 - 0.40) = 6.39%

So, 3rd option is correct.