Question

1. What is the difference between valuing a debt security and valuing the equity of a company? Explain

2. Assume interest rate on a company's debt is 6% and that the company's tax rate is 35%. Compute the cost of debt capital. Show your calculation.

3. Assume that a company's market beta equals 0.8, the risk-free rate is 5%, and the market return equals 8%. Compute the company's cost of equity capital. Show your calculation.

Answer 1

1) Difference between valuing debt security and equity of company

Valuing debt security ,tax component is considered because interest on tax  is deductible while in case of valuing equity no tax is considered.

2)Cost of debt capital is = interest rate (1-tax rate )

= 6 (1-.35)

=3.9%

3) Cost of equity capital = Risk free interest rate + beta(market return - risk free return)

= 5+0.8(8-5)

=7.4%