Calculate the cost of debt for espondera inc


Question:

Espondera Inc

Espondera Inc is a small unquoted company that needs to raise funds in order to invest in a new project. The company wants to issue 10-year bonds and its finance director is trying to work out the cost of debt in order to assess the profitability of the company.

The following information is available for the company

Total assets $120 million

Net income $6 million

Type of proposed debt Subordinated

Long-term debt $14 million

Income before interest and taxes $8 million

Interest payments $1.0 million

The earnings of the company for the last 5 years are as follows

Year

Earnings

20X6

$5m

20X5

$4.2m

20X4

$3.2m

20X3

$3.8m

20X2

$2.2m

The finance director has decided to use the Kaplan Urwitz model for unquoted companies to asses the cost of debt.

The Kaplan-Urwitz model for unquoted companies is given by

Y= 4.41 + 0.001SIZE + 6.40PROFITABILITY - 2.56DEBT - 2.72LEVERAGE + 0.006INTEREST - 0.53COV

The classification of companies into credit rating categories is done in the following way

Score (Y) Rating category

Y > 6.76 AAA

Y > 5.19 AA

Y > 3.28 A

Y > 1.57 BBB

Y > 0 BB

The following table gives the yield to maturity for 10-year corporate bonds by credit category

Rating

Cost of debt (Yield to maturity)

AAA

6.8%

AA

7.3%

A

7.8%

BBB

8.4%

BB

9.4%

B

10.5%

Calculate the cost of debt for Espondera Inc.

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Accounting Basics: Calculate the cost of debt for espondera inc
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