Purchase Solution

# Cost of debt, required return, WACC

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1) 10 year bonds have YTM of 9.186%. The company can sell new 10 year bonds to provide this same interest rate, but flotation costs will be 5%. Calculate after tax cost of existing debt & after tax cost of new debt.

2) Few friends are planning to open a restaurant. Each friend has to invest \$20,000 for equity capital. Tom is considering joining this group and to determine the reasonable opportunity cost for equity invested this way. He spoke with an analyst and Tom was advised that a typical business like this would sell for about 5 times earnings. Tom looked at stock market to consider alternatives. P/E ratios for smaller companies was averaging 6. Higher risk companies traded had betas of 2.0 and above. Tom thought this investment in restaurant would be of similar risk to investment in stock in stock with a beta of 2.0. Risk free rate is 8% and market risk premium 6.3%. What required return should Tom use in evaluation of business opportunity being considered ?

3) A company has equity of market value 1 million, debt of 2 million and financial lease calling for payments of 100,000 a year for 10 years. Cost of equity 15%, interest rate 10%, tax rate 35% , after tax cost of debt is 6.5%. The lease is of similar risk to the debt, so the value of lease payments can be found by discounting them in the interest rate on the debt. What is WACC?

##### Solution Summary

1) after tax cost of existing debt & after tax cost of new debt
2) required return on investment in restaurant
3) weighted average cost of capital (WACC) .

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