- Published: October 19, 2022
- Updated: October 19, 2022
- University / College: University of California, Berkeley (UCB)
- Level: School
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Principles of Finance Questions Question The best estimate of cost is estimated using Yield to maturity (YTM) since the bondhas a maturity period of 20 years.
YTM = × (1-t) (Brigham & Houston 364), where m is the par value of the bond, vd is the current market value of the bond, t is the tax rate. Interest= 7. 25% * 1, 000 = $72. 5
YTM =× (1-0. 4) = × 0. 6 = 5. 04%
Using CAPM the cost of equity is determined by:
Kd= Rf+(ERm-Rf)*ßd (Brigham & Houston 468), where Rf is the risk free rate, ERm is the Expected market return, and ßd is the beta factor.
Kd = 3. 5 + (11. 5-3. 5)*1. 25 = 13. 5%.
Equity in this case is expensive that debt. According to Brigham & Houston (465), this is explained by two factors:
a) Debt enables the company to get a tax shield benefit. The cost is always calculated as a after tax cost. This reduces the cost of debt.
b) The equity holders demand a risk premium for uncertainty of income for their investment. The risk premium hence is calculated as (ERm-Rf)*ßd. This increases the cost of equity.
First the market values of both debt and equity are determined (Brigham & Houston 463-469).
Market value of equity= Number of shares × MPS = 10m × $15. 25=$152. 5 million, where MPS is market price per share.
Market value of debt= number of bonds × market value of bond = 40, 000 × $875 =$35 million
The total market value = $35 m + $152. 5 m = $187. 5 m
Then the weights of the components are determined.
For equity weight = = 0. 81
For debt weight = = 0. 19
ATWACC = weke+ wdkd=×5. 04 + 13. 5 = 6. 62%
From question 3 the ATWACC has been calculated to be 6. 62%. This is the average cost of the capital invested. A return on assets (ROA) is a measure of how a company has used its assets to generate income (Brigham & Houston 233). It is a measure of the profitability of a firm in relation to its total assets. It is normally arrived at by dividing the net income by total assets. Capital generated either from the equity holders or debt from financial institution is used to acquire assets. In effect assets are a direct derivation from capital employed. This means return on assets should always be more than cost of capital when a company is doing well. A ROA of 10% is impressive compared to the average cost of capital of 6. 62%. This means that the company invested capital whose average cost was 6. 62% to generate a return of 10%. This implies that value was created which is equal to 3. 38%.
Brigham, Houston. Fundamentals of Financial Management, 10th edition, New York: John Wiley & Sons, 2004. Print.