Estimate the cost of capital for company A. The company has 4 million shares and 125 000 bonds outstanding at par value $1 000. In addition, it has $20 million in short-term debt from its bank. The target capital structure ratio is 55 percent equity, 40 percent long-term debt, and 5 percent short-term debt. The current capital structure has temporarily moved slightly away from the target ratio. The companyʼs shares currently trade at $50 with a beta of 1.03. The book value of the shares is $16. The annual coupon rate of the bonds is 9 percent, they trade at 108 percent of par, and they will mature in ten years. Interest on the short-term debt is 3.5 percent. The current yield on ten-year government bonds is 5.2 percent. The market risk premium is 5 percent. The corporate tax rate applicable is expected to be 35 percent. Based on these data, calculate the cost of capital for company A.
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
Estimate the cost of capital for company A. The company has 4 million shares and 125 000 bonds outstanding at par value $1 000. In addition, it has $20 million in short-term debt from its bank. The target capital structure ratio is 55 percent equity, 40 percent long-term debt, and 5 percent short-term debt. The current capital structure has temporarily moved slightly away from the target ratio. The companyʼs shares currently trade at $50 with a beta of 1.03. The book value of the shares is $16. The annual coupon rate of the bonds is 9 percent, they trade at 108 percent of par, and they will mature in ten years. Interest on the short-term debt is 3.5 percent. The current yield on ten-year government bonds is 5.2 percent. The market risk premium is 5 percent. The corporate tax rate applicable is expected to be 35 percent.
Based on these data, calculate the cost of capital for company A.
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