Energetic Engines is trying to estimate its cost bonds that pay $20 interest every six months. Each bond, which has a $1,000 face value and matures in six years, is currently selling for $900. Estimate Energetic’s cost of retained earnings using the bond-plus-risk-premium approach.

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Asked Apr 5, 2019
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Energetic Engines is trying to estimate its cost bonds that pay $20 interest every six months. Each bond, which has a $1,000 face value and matures in six years, is currently selling for $900. Estimate Energetic’s cost of retained earnings using the bond-plus-risk-premium approach.

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Expert Answer

Step 1

Calculating the value of bond yield. We have,

Bond yield = Coupon Payment / Face value of bond

Here,

Coupon payment = $ 20 (Semi-annually)

Coupon payment = $ 20 x 2 = $ 40 (Annually)

Face value of bond = $ 1,000

By substituting these value in the above formula. we get;

Bond yield = $ 40 / $ 1,000 = 0.04

Bond yield = 0.04*100

Bond yield = 4 %

Step 2

Calculating the value of risk premium. We have,

The risk premium is the amount over the risk-free rate an investment makes. The risk premium is a general estimate usually ranging between 5 % to 7 %.For this question, we are assuming 5 % risk premi...

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