Find the cost of debt for GE and Alstom. a) GE has a credit rating of AA+ and Al

Question

Find the cost of debt for GE and Alstom. a) GE has a credit rating of AA+ and Alstom has a credit rating of BBB. Which one is riskier? Why? b) Default risk premium on AA+ rated bonds are 3% and BBB rated bonds are 6%. The marginal tax rate for both companies is 30%. What is the after tax cost of debt for GE and Alstom if the risk free rate (10 year US Treasury rate) is 2.5% ? Suppose both GE and Alstom have 60% debt and 40% equity in their capital structure. They do not have any preferred stock. What is the WACC of GE and Alstom? Which one has a higher WACC? Why? Suppose both GE and Alstom have a major project that they are considering. What should be the minimum return on the project, so that they will take on the project?

Explanation / Answer

Answer:

On the basis of your comment...i am ignoring the question you put on the board...

Here i summarised your question:

1. What is the cost of equity, given the following facts : - beta = 1,23 (for both GE and Alstom) - Risk free rate = 2,5% - Market rate of return = 29,60%

2. And then, what is the after-tax cost of debt for Alstom and GE ? (GE has a default risk premium of 3% and Alstom 6%)

3. Suppose both GE and Alstom have 60% debt and 40% equity in their capital structure, without any preferred stock. What are their WACC ? Which one has a higher WACC and why?

4. Suppose both GE and Alstom have a major project. What should be the minimum return of the project so that they will take it on?

Now, i am giving answers on by one of your questions..

1) As per Capital Asset Pricing Model,

Cost of Equity (for both GE and Alstom) = Risk free return + Beta (Market Return - Risk Free Return) = 2.50% + 1.23 (29.60% - 2.50%) = 2.50% + 33.33% = 35.83%

2) After-tax Cost of Debt (GE) = Interest Rate (1 - Tax) = 3% (1 - 0.30) = 2.10%

After Tax Cost of Debt (Alstom) = Interest Rate (1 - Tax) = 6% (1 - 0.30) = 4.20%

3) WACC (Weighted Average Cost of Capital)

WACC (for GE) = (Cost of Equity x Weight of Equity) + (Cost of Debt x Weight of Debt) = (35.83% x 0.40) + (2.10% x 0.60) = 14.332% + 1.26% = 15.592%

WACC (for Alstom) = (Cost of Equity x Weight of Equity) + (Cost of Debt x Weight of Debt) = (35.83% x 0.40) + (4.20% x 0.60) = 14.332% + 2.52% = 16.852%

Alstom has higher WACC. Reason for higher WACC of ALstom is they have higher risk because of higher debt rate.. Cost of Equity is same for both the firms but Cost of Debt are different. It shows High Cost of Debt means high risk and low cost of debt means low risk involved in payment of interest to debt holders.

4) Minimum Return of Project requried to take project will be WACC.

For GE = 15.592%

For Alstom = 16.852%

If they get above minimum required return from project, they will be able to meet out the expectation of equity shareholders and debt holders..

Hope above solution works out for you....

Thank You..

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