• A. Calculate Allied’s cost of debt. (4 marks)
The cost of debt is the YTM of the bonds, so:
P0: $950 = $80(PVIFAR%,9) + $1,000(PVIFR%,9)
PMT: 80 PV: 950 FV: 1000 N: 9 I:
YTM = [80 + (1000 – 950) / 9] / 1000 + 950/ 2
R = 85.56 / 975 = 0.0877 or 8.78%
FC = 8.82%
Cost of debt is:
RD = (1 – 0.30)(0.0882) = 0.06174 or 6.174%
B. Calculate Allied’s cost of equity. (4 marks)
3.5 + 1.5 * 1.5 = 5.75
C. Calculate Allied’s market value weighted average cost of capital. (4 marks)
Market Value Weight Cost of Capital Weight X Cost
Debt 950,000,000.00 0.940 0.0618 0.0581%
Common Stock 60,000,000.00 0.06 0.0575 0.0345%
Preferred stock 0.000 0.000%
1,010,000,000 1.0 WACC 0.0926%
9.26%
MV of debt = $1,000,000 ($950)= $950,000, 000
MV of common stock = $3,000,000 ($20) = $60,000,000
D. Explain why the cost of debt is cheaper than the cost of equity. (3 marks)
First of all, debt is typically secured by assets, whether real estate, machinery, receivables, inventory, or other things of value, which may be seized by the lender in case of default by the borrower. Equity ownership, by contrast, is not accompanied by any kind of security interest in the company financed by the equity holder. The equity holder cannot seize anything, the sole remedy of an equity holder generally being the right to vote at a shareholders’ meeting.
Secondly, the cost of equity is typically much higher than the cost of debt is that in the event of bankruptcy of a company, debt holders are satisfied in full before equity holders receive any proceeds of liquidation whatsoever.
Thirdly, a company must pay holders of debt an interest rate, even if the company is loss-making (and failure to pay interest or to achieve debt coverage ratios may put the company into default and force a liquidation). Equity holders, by contrast, are paid dividends only to the extent that the company has been profitable, once all obligations in the ordinary course (e.g. servicing of interest payments) have been satisfied.
The following balance sheet extract relates to the Allied Insurance Company
Bonds Payable $1,000,000
Preferred Stock $2,000,000
Common Stock $3,000,000
Additional Information:
1. The bonds are 8%, annual coupon bonds, with 9 years to maturity and are currently selling for 90% of par.
2. The company’s common shares which have a book value of $25 per share are currently selling at $20 per share.
3. The preferred shares are 5% preferred shares with a book value of $100 per share. These shares are currently selling at $80 per share.
4. The company has an equity beta of 1.35 and the current Treasury bill rate is 3.0%. The market risk premium is 1.5%
5. The company’s tax rate is 30%.
A. Calculate Allied’s cost of debt. (4 points)
B. Calculate Allied’s cost of equity. (3 points)
C. Calculate Allied’s cost of preferred shares (3 points)
D. Estimate Allied’s market value weighted average cost of capital. (3 points)
E. Explain why the cost of debt is cheaper than the cost of equity. (2 points)
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