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A company has bonds outstanding that mature in 26 years with an annual coupon of 7
A company has bonds outstanding that mature in 26 years with an annual coupon of 7.5%. The bonds have a face value of $1,000 and sell in the market today for $920.
The risk-free rate is 6 percent. The market risk premium is 5 percent. The stock's beta is 1.2.
The company's tax rate is 40 percent.
The company's target capital structure consists of 70 percent equity and 30 percent debt.
The company uses the CAPM to estimate the cost of equity and does not include flotation costs as part of its cost of capital.
What is the required rate of return on debt?
Expert Solution
We can calculate the cost of debt by using the following formula in excel:-
=rate(nper,pmt,-pv,fv)
Here,
Rate = Cost of debt
Nper = 26 periods
Pmt = Coupon payment = $1,000*7.5% = $75
PV = $920
FV = $1,000
Substituting the values in formula:
= rate(26,75,-920,1000)
= 8.26%
Required return on debt = Cost of debt * (1 - Tax rate)
= 8.26% * (1 - 40%)
= 4.95%
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