Question

A stock analyst has obtained the following information about J-Mart, a large pharmacy chain: - The company has noncallable bonds with 20 years maturity remaining and a maturity value of $1,000. The bonds have a 12 percent annual coupon and currently sell at a price of $1,273.86. - Over the past four years, the returns on the market and on J-Mart were as follows: Year Market J-Mart 12.0% 14.5% 17.2% 22.2% 3.8% -7.5% 20.0% 24.0% . The risk-free rate is 6.35 percent, and the expected return on the market is 11.35 percent. The company's tax rate is 35 percent. The company anticipates that its proposed investment projects will be financed with 70 percent debt and 30 percent equity. What is the company's estimated corporate cost of capital (CCC)? Hint: Refer to Chapter 5 Model to see how to estimate beta (b). ANSWER Spreadsheet solution: Number of periods (nper) Coupon rate 12% Maturity value (.e. FV) $1,000 Annual coupon payment (pmt) $120 Current Price (PV) $1,273.86 R(Rd) RF R(Rm) R(Re) wd R(Rd) T- =C32 R(Re) CCC

Answer 1

cost of debt Rd = YTM of bonds

YTM is calculated using RATE function in Excel with these inputs :

nper = 20 (20 years to maturity with 1 annual coupon payment each year)

pmt = 1000 * 12% (annual coupon payment = face value * annual coupon rate. This is a positive figure as it is an inflow to the bondholder)

pv = -1273.86 (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 9.00%. This is the YTM, or Rd.

Beta = covariance of returns between market and J-Mart / variance of returns of J-Mart

Covariance and variance are calculated using COVARIANCE.S and VAR.S functions in Excel.

Beta = 1.1028

A B 1 Year market 1 12.0% 2 17.2% 3 -3.8% 20.0% 6 Covar. 0.0154 7 Variance 0.0139 8 beta 1.1028 C J-mart 14.5% 22.2% -7.5% 24.0%

1 Year 21 market 0.12 0.172 -0.038 0.2 =COVARIANCE.S(B2:B5,C2:05) =VAR.S(B2:B5,C2:05) =B6/B7 J-mart 0.145 0.222 -0.075 0.24 3 2 4 3 5 4 6 Covar. 7 Variance 8 beta

cost of equity Re = risk free rate + (beta * (expected market return - risk free rate))

CCC = (weight of debt * before tax cost of debt * (1 - tax rate)) + (weight of equity * cost of equity)

before tax cost of debt = YTM of bonds

CCC = 7.65%

| AB nper coupon rate FV PMT PV Rd 20 12% 1000 120 -1273.86 9.00% Rm 6.35% 11.35% 1.1028 11.86% 70.00% 9.00% 35.00% 30.00% 11.86% 7.65% we