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.