Exhibit 3: Financing AssumptionsThe following assumptions are used to determine the cost of capitalHistorically, the company tried to maintain a debt ratio equal to 0.28. This ratio wasused, because lowering the debt implies giving up the debt tax shield, and increasing itmakes debt service a burden on the firm's cash flow. In addition, increasing the debtlevel may cause a reduced rating of the company's bonds. The marginal tax rate is 40%.All the numbers are expressed in today's dollars.Cost of debt:The company's bond rating is roughly at the high end of the A range. Surveying the debtmarket yielded the following information about the cost of debt for different rating levelsBond ratingВВBAAAInterest cost range6% 7%5% - 6 %7%~8.5%Cost of equity:The current 10-year Treasury notes have a yield to maturity of 3% and the forecast for theS&P 500 market premium is 6%. The company's overall ß is 1.2BanalysisGeneral UniversalTransports Inc.Trucks InternationalRoad KingCompanyRedTrucksTrucksBirdTrucksOverall B1.21.2131.321.21.09Debt to equity0.40.30.50.450.350.25Percentage of504590958585income fromtrucks

Question
Asked Nov 20, 2019
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What is the company’s cost of capital?

1. CAPM = rrf + (rm – rrf)B = required rate of return on equity
r rf = risk-free rate of return = 10-year Treasury rate = 3%
S&P market premium (in parenthesis) is the extra return to cover risk offered in the stock market = 5%. B = Beta of company = 1.2

 

2. WACC = wdrd(1-t) + were = weighted average cost of capital
Weights of debt and equity: Given debt ratio, that is, debt to total assets = 28%. Cost of debt is bond rating at high end of A average = 6%. Tax rate given 40%.

Exhibit 3: Financing Assumptions
The following assumptions are used to determine the cost of capital
Historically, the company tried to maintain a debt ratio equal to 0.28. This ratio was
used, because lowering the debt implies giving up the debt tax shield, and increasing it
makes debt service a burden on the firm's cash flow. In addition, increasing the debt
level may cause a reduced rating of the company's bonds. The marginal tax rate is 40%.
All the numbers are expressed in today's dollars.
Cost of debt:
The company's bond rating is roughly at the high end of the A range. Surveying the debt
market yielded the following information about the cost of debt for different rating levels
Bond rating
ВВB
AA
A
Interest cost range
6% 7%
5% - 6 %
7%~8.5%
Cost of equity:
The current 10-year Treasury notes have a yield to maturity of 3% and the forecast for the
S&P 500 market premium is 6%. The company's overall ß is 1.2
Banalysis
General Universal
Transports Inc.
Trucks International
Road King
Company
Red
Trucks
Trucks
Bird
Trucks
Overall B
1.2
1.2
13
1.32
1.2
1.09
Debt to equity
0.4
0.3
0.5
0.45
0.35
0.25
Percentage of
50
45
90
95
85
85
income from
trucks
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Exhibit 3: Financing Assumptions The following assumptions are used to determine the cost of capital Historically, the company tried to maintain a debt ratio equal to 0.28. This ratio was used, because lowering the debt implies giving up the debt tax shield, and increasing it makes debt service a burden on the firm's cash flow. In addition, increasing the debt level may cause a reduced rating of the company's bonds. The marginal tax rate is 40%. All the numbers are expressed in today's dollars. Cost of debt: The company's bond rating is roughly at the high end of the A range. Surveying the debt market yielded the following information about the cost of debt for different rating levels Bond rating ВВB AA A Interest cost range 6% 7% 5% - 6 % 7%~8.5% Cost of equity: The current 10-year Treasury notes have a yield to maturity of 3% and the forecast for the S&P 500 market premium is 6%. The company's overall ß is 1.2 Banalysis General Universal Transports Inc. Trucks International Road King Company Red Trucks Trucks Bird Trucks Overall B 1.2 1.2 13 1.32 1.2 1.09 Debt to equity 0.4 0.3 0.5 0.45 0.35 0.25 Percentage of 50 45 90 95 85 85 income from trucks

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Step 1

1.

Risk-Free Rate (rrf) = 3% or 0.03

Market Premium (rm – rrf) = 5% or 0.05

Beta (B) = 1.2

 

...

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Cost of Equity f + (m -rf)x B = 0.03+ (0.05-0.03) x 1.2 =0.03+0.02 x1.2 0.03 0.024 0.054 or 5.4%

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