Corporate Finance: Quiz 3

This quiz is worth 10% and you have 30 minutes.

1. You have been provided the information on the after-tax cost of debt and cost of capital that a company will have at a 10% debt ratio, and asked to estimate the after-tax cost of debt and cost of capital at 20%. The long term treasury bond rate is 7%. ( 5 points)

Debt Ratio

10%

20%

Extra Column

$ Debt

$ 1,500

EBIT

$ 1,000

Interest Expenses

$ 120

Interest Coverage Ratio

8.33

Bond Rating

AA

Interest Rate

8.00%

After-tax Cost of Debt

4.80%

Beta

1.06

Cost of Equity

12.83%

Cost of Capital

11.78%

The interest coverage ratios, ratings and spreads are as follows:

Coverage Ratio

Rating

Spread over Treasury

> 10

AAA

0.30%

7 -10

AA

1.00%

5 - 7

A

1.50%

3 - 5

BBB

2.00%

2- 3

BB

2.50%

1.25 - 2

B

3.00%

0.75 - 1.25

CCC

5.00%

0.50 - 0.75

CC

6.50%

0.25 - 0.50

C

8.00%

< 0.25

D

10.00%

2. CSL Corporation is a mid-sized transportation firm with 10 million shares outstanding, trading at $ 25 per share and debt outstanding of $ 50 million. It is estimated that the cost of capital, which is currently 11%, will drop to 10%, if the firm borrows $ 100 million and buys back stock. Estimate the expected change in the stock price if the expected growth rate in operating earnings over time is 5%.