During the few previous years, Company J has been too constrained with the aid of high price of capital to make investments. Recently, it is observed that, capital costs have been declining and company has decided to look severely at a primary expansion program suggested by marketing and advertising department. For this purpose, the major task for the company is to estimate its cost of capital. To determine: Cost of equity using bond-yield-plus-judgemental-risk-premium approach.

Question

Treasury securities are issued and backed by the U.S. government and, therefore, are considered to be the lowest-risk securities on the market. As an investor looking for protection against inflation, you are considering the purchase of inflation-adjusted bonds known as U.S. Treasury Inflation-Protected Securities (TIPS). With these securities, the face value (which is paid at maturity) and the bond interest rate (which is paid semiannually) is regularly adjusted to account for inflation. However, for this problem only, assume the semi-annual interest payment (called the bond dividend) remains the same. You purchased a 10-year $10,000 TIPS bond with dividend of 4% per year payable semiannually (i.e., $200 every 6 months). Assume there is no inflation adjustment for the first 5 years, but in years 6 through 10, the bond face value increases by $850 each year. You use an expected investment return of 11% per year compounded semiannually. NOTE: This is a multi-part question. Once an…

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Chapter 11, Problem 6MC

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Case summary:

During the few previous years, Company J has been too constrained with the aid of high price of capital to make investments. Recently, it is observed that, capital costs have been declining and company has decided to look severely at a primary expansion program suggested by marketing and advertising department. For this purpose, the major task for the company is to estimate its cost of capital.

To determine: Cost of equity using bond-yield-plus-judgemental-risk-premium approach.

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