A 20-year $1,000 fixed-rate non-callable bond with 8% annual coupons currently sells for $1,105.94. Assuming a 30% marginal tax rate and an additional risk premium for equity relative to debt of 5%, the cost of equity using the bond-yield-plus-risk-premium approach is closest to:
First, determine the yield to maturity, which is the discount rate that sets the bond price to$1,105.94 and is equal to 7%. This calculation can be done with a financial calculator:
FV = ﹣$1,000, PV = $1,105.94, N = 20, PMT = ﹣$80, solve for i, which will equal 7%.
The bond-yield-plus-risk-premium approach is calculated by adding a risk premium to the cost of debt (i.e., the yield to maturity for the debt), making the cost of equity 12.00% (= 7% +5%).