Scribd Logo
Upload

Welcome to Scribd!

  • 64 views

    Cost of Debt - Financial Markets

    Uploaded by

    Jericho Dupaya

    Copyright:

    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd

    Cost of Debt - Financial Markets

    Uploaded by

    Jericho Dupaya
    64 views6 pages

    Original Title

    Cost of Debt_financial Markets

    Copyright

    © © All Rights Reserved

    Available Formats

    DOCX, PDF, TXT or read online from Scribd

    Did you find this document useful?

    Is this content inappropriate?

    Copyright:

    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
    64 views6 pages

    Cost of Debt - Financial Markets

    Uploaded by

    Jericho Dupaya

    Copyright:

    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
    of 6

    Financial Markets:

    PROBLEM

    1. A firm has determined its optimal capital structure, which is


    composed of the following sources and target market value
    proportions:

    Source of Capital Target Market Proportions


    Long-term debt P15 million
    Preference share 2.5 million
    Ordinary share equity 32.5 million

    Debt: The firm can sell a 20-year, P1,000 par value, 9 percent bond for P980.
    A flotation cost of 2 percent of the face value would be required in addition to
    the discount of P20.

    Using approximated yield to maturity formula.

    Preference share: The firm has determined it can issue Preference share at
    P65 per share par value. The share will pay an P8.00 annual dividend. The
    cost of issuing and selling the share is P3 per share.

    Ordinary share: The firm’s ordinary share is currently selling for P40 per
    share. The dividend expected to be paid at the end of the coming year is
    P5.07. Its dividend payments have been growing at a constant rate for the last
    five years. Five years ago, the dividend was P3.45. It is expected that to sell, a
    new ordinary share issue must be underpriced at P1 per share and the firm
    must pay P1 per share in flotation costs. Additionally, the firm’s marginal tax
    rate is 40 percent.
    COST OF DEBT

    Formula:
    Cost of Debt = (Interest+ (Par Value-Net Proceed)/ (no.of years))/ ((Par Value Net Proceed)/2)

    Interest= Par Value x Bond Rate


    = ₱1,000 x 9%
    = ₱90
    Par Value= ₱1,000
    Flotation Cost= ₱20
    Net Proceed= Discounted Price – Flotation Cost
    = ₱980 – ₱20
    =₱960
    No.of years= 20 years
    Marginal Tax Rate= 40%

    Cost of Debt = (₱9,000+ (₱1,000-₱960)/20)/ ((₱1,000+₱960)/2)


    = (₱90+ ₱2)/₱980
    = ₱92/₱980
    Cost of Debt = 9.39% (before tax)

    FORMULA:
    Cost of Debt (After Tax) = Cost of Debt before tax (1-tax rate)
    Cost of Debt= 9.39% (1-0.4)
    Cost of Debt=5.6%

    COST OF PREFERENCE SHARE


    Formula:
    Cost of Preference Share= (Dividend per share)/(Net Proceed )

    Market Value = ₱65


    Dividend per share= ₱8
    Flotation Cost =₱3
    Net Proceed= Market Value – Flotation Cost
    = ₱65 – ₱3
    =₱62
    Cost of Preference Share= ₱8/₱62
    Cost of Preference Share=12.9%

    COST OF ORDINARY SHARE


    Formula:
    Cost of Ordinary Share= (Expected Dividend @ year-end)/ (Market Value) + growth rate

    Market Value = ₱ 40
    Expected Dividend= ₱ 5.07
    Flotation Cost = ₱ 1
    Growth Rate= ((Final Dividend)/ (Initial Dividend)) ^(1/period)-1
    = (5.07/3.45)1/5-1
    =8%
    Cost of Preference Share= (₱5.07/₱ 39-1) +8%
    = (₱5.07/₱ 38) +8%
    Cost of Preference Share=21.34%

    Weighted Ave.
    Source of Capital Structure Cost of Cost of Capital
    Capital (Based on Fraction Capital (Fraction x
    Market Value) Cost of Capital)

    Long-term P15,000,000 (15million/50million) = 5.6% 1.68%


    debt 0.3 or 30%
    Preference (2.5million/50million) =
    share 2,500,000 0.05 or 5% 12.9% 0.65%

    ordinary (32.5million/50 million) =


    share equity 32,500,000 0.65 or 65 % 21.34% 13.87%

    Total P50,000,000 1 or 100% 16.20%

    2. KHUBID-20 has compiled the following financial data:


    Source of Capital Book Value Market Value Cost
    Long-term debt P10,000,000 P8,500,000 5.0%
    Preferenceshare 1,000,000 1,500,000 14.0
    ordinaryshare equity 9,000,000 15,000,000 20.0
    P20,000,000 P25,000,000

    (a) Calculate the weighted average cost of capital using book value weights.

    Source of Capital Fraction

    Long-term Debt (10,000,000/20,000,000) = 0.5 or 50%


    Preference Share (1,000,000/20,000,000) =0.05 or 5%
    Ordinary Share Equity (9,000,000/20,000,000) =0.45 or 45%
    100%
    ra = (wi x ri ) + (wp x rp ) + (ws x rr or n )
    = (50% x 5%) + (5% x14%) + (45% x 20%)

    = 2.5 + 0.7 + 9

    =12.2%

    (b) Calculate the weighted average cost of capital using market value weights.

    Source of Capital Fraction

    Long-term Debt (8,500,000/25,000,000) =0.34 or 34%


    Preference Share (1,500,000/25,000,000) =0.06 or 6%
    Ordinary Share Equity (15,000,000/25,000,000) =0.6 or 60%
    100%
    ra = (wi x ri ) + (wp x rp ) + (ws x rr or n )

    = (34% x 5%) + (6% x14%) + (60% x 20%)


    = 1.7 + 0.84 +12
    =14.5%

    3. PORT LINER has compiled the following data relative to current costs of its basic sources of external
    capital—long-term debt, Preferenceshare, and Ordinaryshare equity—for variant ranges of financing.
    Table 11.4
    Source of Cost Range of Total New Financing
    Capital
    Long-term debt 7% P0–P2,000,000
    8 P2,000,001–P3,000,000
    10 P3,000,001 and above
    Preferenceshare 19% P0–P 960,000
    21 P960,001 and above
    Ordinaryshare 20% P0–P 700,000
    24 P700,001–P1,600,000
    26 P1,600,001–P2,200,000
    30 P2,200,001 and above

    The firm expects to have P350,000 of current retained earnings in the coming year at a cost of 20
    percent; once these retained earnings are exhausted, the firm will issue new ordinaryshare. The
    company’s target capital structure proportions are used in calculating the weighted average cost of
    capital follow.
    Source of Capital Target Capital
    Structure
    Long-term debt 0.25
    Preferenceshare 0.25
    Ordinaryshare equity 0.50
    a. Calculate the firm’s cost of capital prior to exhausting the firm’s available current retained
    earnings.
    ka = (7) (0.25) + (19) (0.25) + (20) (0.50)
    ka = 1.75 + 4.75 + 10
    ka = 16.5%

    b. Calculate the firm’s cost of capital for P2,000,000 of total new financing.

    ka = (7) (0.25) + (21) (0.25) + (26) (0.50)


    ka = 1.75 + 5.25 + 13
    ka = 20%

    You might also like