3. Comment on the Kyle Brooks estimate in Exhibit 6? Based on the Kyle Brooks’ cost of capital estimation in Exhibit 6, we would say that theestimation is totally wrong. For the cost of debt, we all know that the coupon rate is equal to pre-tax costof debt. In the case, Brooks uses the interest expense the firm is currently paying as the cost of debt. Theproblem is that this approach ignores the prevailing conditions in the market that are relevant to currentinvestors. A better approach is to estimate what investors currently require based on prevailingrates. One approach is to estimate the prevailing yield to maturity (YTM) on Royal Mail long-term bonds.Using the bond that currently trading at a price of 106, one can estimate the prevailing YTM at 3.648%.They also can use alternative approach by use the prevailing yields for bonds of similar credit ratings.According to case Exhibit 6, the bond rating on Royal Mail bonds is currently BBB. BBB is regarded ashaving an adequate capacity to pay interest and repay the principal. From case Exhibit 8, we observe thatBBB-rated bonds are currently yielding 3.776%. Therefore, both of these estimates could be used asreasonable estimates of the cost of debt for Royal Mail. For the cost of equity in Exhibit 6, it wasestimated using the current dividend yield for Royal Mail. Actually, the dividend yield does not take intoaccount expected appreciation in dividends or of the stock price. Therefore, we suggest that Brookshould use a security market line (SML) approach which also can estimate the expected return on theRoyal Mail’s equity. This is because, from our opinion, SML approach is applicable to the firm other thanjust those with steady dividend growth. For the risk-free rate, we suggest that Brook should use thecurrent 10-year government bond yield of 2.03%. This is because, we think that 5-year government bondyield is not a long-term bond and it fails to incorporate the inflation expectations of long-term debt.Thus, a better approach is to use the 10-year rate. The approach in Exhibit 6 uses a beta estimate of 0.65.A value well below zero will be consistent with their expectations of the risk profile of a postal companysuch
You've reached the end of your free preview.
Want to read all 4 pages?