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Dear Tutor,
Please consider the extract below and answer the follow-up question.
THE EXCERPT:
B Co is a hot air balloon manufacturer whose equity: debt ratio is 5:2.
The corporate debt, which is assumed to be risk-free, has a gross
redemption yield of 11 %. The beta value of the company’s equity is
1.1. The average return on the stock market is 16%. The corporation
tax rate is 30%.
The company is considering a water bed manufacturing project. S Co is
a water bed manufacturing company. It has an equity beta of 1.59 and
an equity: debt ratio of 2:1. B Co maintains its existing capital structure
after the implementation of the new project.
What would be a suitable risk adjusted cost of equity to apply to the
project?(Reference: Illustration 1; Chapter 18 – Capital Structure; Kaplan Study Text).
THE QUESTION:
Why is the risk-free rate referred to as “gross redemption yield”?I’m not used to seeing it like this in my practised questions.
I don’t want to rote learn it so I need to know why it is called so.It states in the question that the corporate debt, is assumed to be risk-free and has a gross
redemption yield of 11 %.
This indicates that the debt is considered to have a very low likelihood of default, meaning that the issuer is expected to meet its obligations to pay interest and repay the principal.
So that’s why it is assumed to be risk free as the assumption is often made for certain types of corporate debt, particularly when the company has a strong credit rating or when the debt is backed by secure assets.
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