Corporate Finance 2

Question

A coma has 14 million shares of common stock outstanding, 900,000 shares of 9 percent preferred stock outstanding and 220,000 ten percent semiannual bonds outstanding, par value $1,000 each. The common stock currently sells for $42 per share and has a beta of 1.15, the preferred stock currently sells for $80 per share, and the bonds have 17 years to maturity and sell for 91 percent of par. The market risk premium is 11.5 percent, T-bills are yielding 7.5 percent, and the firm's tax rate is 32 percent. What discount rate should the firm apply to a new project's cash flows if the project has the same risk as the firm's typical project?

Answer 1

For this specific, since the company capital structure includes common stocks, preferred stock, and semi-annual bonds. You would need to calculate the WACC (Weighted Average Cost of Capital) of these 3 types of capital raising.

WACC = ReWe + RpWp + Rd(1-Tc)Wd

Re - cost of equity

We - Weighted Average of Equity

Rp - Cost of preferred stock

Wp - Weighted Average of Preferred Stock

Rd - cost of debt

Tc - Tax rate

Wd - weighted average of debt

Use CAPM (Capital Asset Pricing Model to calculate cost of equity)

Re = Rf + B(Rm - Rf)

Re - cost of equity

B - Beta

Rm - Rf = market risk premium

Use financial calculator or Excel to calculate cost of debt

N = 17 x 2= 34

I/Y = ?

PV = 90% of par = 90% of 1000 (should be a negative number)

FV = 1000

PMT = 10% coupon rate annually x 1000 = 100 per year/2 = $50

Cost of preferred stock is 9%

Calculate Equity Value in the company

Calculate Debt Value in the company

Calculate Preferred Stock Value in the company

Then calculate the weighted average of each (Equity/Debt/Preferred Stock) in the total company value

Plug these infos into the WACC formula above to get the discount rate.