Question 5: Estimating the cost of capital (20 marks) Bonnie is now getting very excited about all important concepts from managerial finance for a business leader like her. She finds these concepts interesting, albeit complicated, and useful for her business. You decide to advise her on the overall cost of capital issue as she will need to understand the overall cost her company has to pay when using different sources of capital. a) The stock above (as discussed on question 3-part a) has beta of 0.60. The Australian market risk premium is 7 per cent. Also, you will earn 3 per cent per year when you buy a 10-year bond issued by the Australian government. What is the cost of equity? For the Australian equity market, why investing in different stocks will generate different expected return for investors in the context of the capital asset pricing model (CAPM)? [6 marks Investors are compensated for taking a risk. The bonds issued by the Australian government are considered risk-free. However, when you invest in these bonds, you still earn a return, as above. Is the theory on risk-expected return incorrect? Briefly explain. [4 marks ] 6 b) For a bond above (as discussed on question 4), the bond is currently traded at $955 in the market. What is the yield to maturity (rate of return on debt or the cost of debt) for this bond? [5 marks] c) As a starting point, you plan to advise Bonnie to issue 300,000 shares and 10,000 bonds. What is the overall cost of capital for Bonnie's soon-to-be listed company? The company's tax rate is 25%. Calculate the expected Weighted Average Cost of Capital for the firm? (Use the market price of stock given in Q3 part (a) and the market price of bond in part (b) above). How would you advise Bonnie in determining the optimal combination between debt and equity capital? Question 5: Estimating the cost of capital (20 marks) Bonnie is now getting very excited about all important concepts from managerial finance for a business leader like her. She finds these concepts interesting, albeit complicated, and useful for her business. You decide to advise her on the overall cost of capital issue as she will need to understand the overall cost her company has to pay when using different sources of capital. a) The stock above (as discussed on question 3-part a) has beta of 0.60. The Australian market risk premium is 7 per cent. Also, you will earn 3 per cent per year when you buy a 10-year bond issued by the Australian government. What is the cost of equity? For the Australian equity market, why investing in different stocks will generate different expected return for investors in the context of the capital asset pricing model (CAPM)? [6 marks Investors are compensated for taking a risk. The bonds issued by the Australian government are considered risk-free. However, when you invest in these bonds, you still earn a return, as above. Is the theory on risk-expected return incorrect? Briefly explain. [4 marks ] 6 b) For a bond above (as discussed on question 4), the bond is currently traded at $955 in the market. What is the yield to maturity (rate of return on debt or the cost of debt) for this bond? [5 marks] c) As a starting point, you plan to advise Bonnie to issue 300,000 shares and 10,000 bonds. What is the overall cost of capital for Bonnie's soon-to-be listed company? The company's tax rate is 25%. Calculate the expected Weighted Average Cost of Capital for the firm? (Use the market price of stock given in Q3 part (a) and the market price of bond in part (b) above). How would you advise Bonnie in determining the optimal combination between debt and equity capital
