Question

Organic Produce Corporation has 6.3 million shares of common stock outstanding, 350,000 shares of 5.8 preferred stock outstanding, and 150,000 of 7.1 percent semiannual bonds outstanding, par value $1,000 each. The common stock currently sells for $74 per share and has a beta of 1.09, the preferred stock currently sells for $107 per share, and the bonds have 20 years to maturity and sell for 109 percent of par. The market risk premium is 6.8 percent, T-bills are yielding 4.3 percent, and the firm’s tax rate is 34 percent.


a. What is the firm's market value capital structure?

b. If the firm 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?

Answer 1

Answer:

(a) The firm's market value capital structure is = 0.698

,0.245

, 0.056 (b))Therefore the rate the firm should use to discount the project's cash flows is 9.35%

Explanation:

From the example given, we solve for both (a) and (b)

Solution

Given:

(a) The Market Equity of Value = Number of Shares  Outstanding Shares*Current Selling Price = 6300000*74 = 466200000

Market  Debt Value of  = Number of Bonds*Current  Price selling = 150000*1000*109% = 163500000

Preferred Stock market value = Number of  shares outstanding *Current Selling Price = 350000*107 = 37450000

Then,

The Total Market Value = 466200000 + 163500000 + 37450000 = 667150000

The Weight of Equity in Capital Structure (E/V) = 466200000/ 667150000 = 0.698

The Weight of Debt in Capital Structure (D/V) = 163500000/667150000 = 0.245

The  Preferred Stock weight  in Capital Structure (P/V) = 37450000/667150000 = 0.056

(b)Cost of Equity =  Free Risk Rate + Beta * Risk Premium Market = 4.3 + 1.09*6.8 = 11.712%

The Cost of Stock Preferred = Current/Return Selling Price = (5.8%*100)/107*100 = 5.421%  

Thus,

Debit cost

Nper = 20*2 = 40

Where

PMT = 1000*.071*1/2 = 35.5  and FV = 1000

PV = 1000*109 = 1090

The Rate is unknown

Tax Cost of Debt After = Rate(Nper, PMT, PV, FV) = Rate(40,30.5,-1090,1000)*2*(1-.34) = 3.538%

Then,

WACC = After Tax Cost of Debt*Weight of Debt + Cost of Preferred Stock*Weight of Preferred Stock + Cost of Equity*Weight of Equity

WACC = 3.538*.245 + 5.421*.056 + 11.712*.698 = 9.345% or 9.35%

Therefore the rate the firm should use to  discount the project's cash flows is 9.35%