The current price of William's 10% coupon price, semiannual payment, nonmalleable with 15 years...

Question:

The current price of William's 10% coupon price, semiannual payment, nonmalleable with 15 years renaming to maturity is $1,140.00. The firm uses the maximum of the risk premium range. What is the bond yield plus risk premium estimate for William's cost of common equity?

A. 10.0%

B. 14.0%

C. 13.3%

D. 12.9%

Equity Premium:

Stocks are riskier investments compared to bonds, and thus command a higher return. The difference between the average return on stocks and that on risk-free bonds, is termed the equity risk premium.

Answer and Explanation:

The answer is C.

We first compute the yield to maturity on the bond, which is the discount rate that equates the present value of the bond to its current market price, i.e.,

  • {eq}\displaystyle \frac{100*(1 - (1 + y)^{-15})}{y} + \frac{1000}{(1 + y)^{15}} = 1140 {/eq}

which yields:

  • {eq}y = 8.3\%{/eq}

Based on historical data, the upper bound for the equity risk premium is 5%. Hence, the maximum risk premium adjustment is 5%. Then the cost of equity is calculated as:

  • cost of equity = cost of bond + equity risk premium =8.3% + 5% = 13.3%.

Learn more about this topic:

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How to Calculate Risk Premium: Definition & Formula

from Financial Accounting: Help and Review

Chapter 5 / Lesson 26
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