Scanlon Inc.'s CFO hired you as a consultant to help her estimate the cost of capital. You have been provided with the following data: rRF = 4.10%; RPM = 5.25%; and b = 1.15. Based on the CAPM approach, what is the cost of equity from retained earnings?
Several years ago the Jakob Company sold a $1,000 par value, noncallable bond that now has 20 years to maturity and a 7.00% annual coupon that is paid semiannually. The bond currently sells for $950, and the company’s tax rate is 40%. What is the component cost of debt for use in the WACC calculation?
To estimate the cost of equity using the Capital Asset Pricing Model (CAPM) approach, you need the following data:
1. Risk-free rate (rRF): Given as 4.10%.
2. Risk premium (RPM): Given as 5.25%.
3. Beta (b): Given as 1.15.
Now, let's calculate the cost of equity:
Cost of equity = rRF + (b * RPM)
Substituting the given values into the equation:
Cost of equity = 4.10% + (1.15 * 5.25%)
Calculating the equation:
Cost of equity = 4.10% + 6.04%
Cost of equity = 10.14%
So, the cost of equity from retained earnings for Scanlon Inc. is 10.14%.
Now let's move on to the next question about estimating the component cost of debt.
To calculate the component cost of debt for the WACC (Weighted Average Cost of Capital) calculation, you need the following information:
1. Bond price: Given as $950.
2. Par value of the bond: Given as $1,000.
3. Coupon rate: Given as 7.00%.
4. Tax rate: Given as 40%.
To estimate the component cost of debt, you need to calculate the yield to maturity (YTM) of the bond. Since the bond is selling at a discount, the YTM will be higher than the coupon rate.
First, let's calculate the annual coupon payment:
Coupon payment = Coupon rate * Par value
Coupon payment = 7.00% * $1,000
Coupon payment = $70
Next, calculate the number of periods remaining until maturity:
Number of periods = Maturity in years * Number of coupon payments per year
Number of periods = 20 * 2 (since the bond pays semiannually)
Number of periods = 40
Now, let's calculate the yield to maturity using the bond price:
Using the formula:
Bond price = (Coupon payment / (1 + YTM/2) ^ Number of periods) + (Par value / (1 + YTM/2) ^ Number of periods)
Substituting the given values:
$950 = ($70 / (1 + YTM/2) ^ 40) + ($1,000 / (1 + YTM/2) ^ 40)
This equation represents a discounted cash flow (DCF) calculation, which you need to solve iteratively to find the YTM. There are financial calculators and software available that can help in solving this equation.
Once you have obtained the YTM, you can calculate the component cost of debt by multiplying it by (1 - Tax rate). Assuming you obtain a YTM of 8%, the component cost of debt would be:
Component cost of debt = YTM * (1 - Tax rate)
Component cost of debt = 8% * (1 - 40%)
Component cost of debt = 4.8%
So, the component cost of debt for Jakob Company in the WACC calculation is 4.8%.