Corporation has 9.8 million shares of common stock outstanding, 420,000 shares o
ID: 2714028 • Letter: C
Question
Corporation has 9.8 million shares of common stock outstanding, 420,000 shares of 5 percent preferred stock outstanding, and 220,000 8.6 percent semiannual bonds outstanding, par value $1,000 each. The common stock currently sells for $46 per share and has a beta of 1.40, the preferred stock currently sells for $96 per share, and the bonds have 15 years to maturity and sell for 117 percent of par. The market risk premium is 8.6 percent, T-bills are yielding 4 percent, and the company’s tax rate is 40 percent. What is the firm’s market value capital structure? If the company is evaluating a new investment project that has the same risk as the firm’s typical project, what rate should the firm use to discount the project’s cash flows?
Corporation has 9.8 million shares of common stock outstanding, 420,000 shares of 5 percent preferred stock outstanding, and 220,000 8.6 percent semiannual bonds outstanding, par value $1,000 each. The common stock currently sells for $46 per share and has a beta of 1.40, the preferred stock currently sells for $96 per share, and the bonds have 15 years to maturity and sell for 117 percent of par. The market risk premium is 8.6 percent, T-bills are yielding 4 percent, and the company’s tax rate is 40 percent. What is the firm’s market value capital structure? If the company is evaluating a new investment project that has the same risk as the firm’s typical project, what rate should the firm use to discount the project’s cash flows?
Explanation / Answer
Market value capital structure Market value of common stock 9800000 shares @ $ 46 450800000 Market value of 5% Preferred stock 420000 shares @ $96 40320000 Market value of 8.6% bonds 220000 bonds @ $ 1170 257400000 The rate the firm should use to discount the project’s cash flows is the WACC of its funds which is found as follows Cost of Common stock= Risk-free rate+ Beta(Market risk premium-Risk-free rate) =(0.04+1.4*(0.086-0.04) 0.1044 ie. 10.44% Cost of Preferred stock= 5% or 0.05 Cost of bond at the current market price of $ 1170 Semi-annual Coupon amt= 8.6%/2*1000= $ 43 n= no.of semi-annual periods still to maturity = 15*2= 30 r= semi-annual rate of interest to be found out Using the PV formula, We equate the above values, 1170=(43*((1-(1+r)^-30)/r))+(1000/(1+r)^30) Solving in an online equation solver, we get the value of semi-annual r to be 0.0338855 0.0678 After-tax cost= Pre-tax cost(1-Tax Rate) 6.78% annual After-tax cost= 6.78(1-0.40)= 4.068 Now we find the WACC Components of capital Market value Weight to total Cost Wt.*cost Common stock 450800000 0.6022551 0.1044 0.062875 5% Preferred stock 40320000 0.0538663 0.05 0.002693 8.6% bonds 257400000 0.3438786 0.04068 0.013989 Total 748520000 1 0.079558 WACC = 7.96%