Question

Shallow Drilling, Inc. has 76,650 shares of common stock outstanding with a beta of 1.47 and a market price of $50.00 per share. There are 14,250 shares of 6.40% preferred stock outstanding with a stated value of $100 per share and a market value of $80.00 per share. The company has 6,380 bonds outstanding that mature in 14 years. Each bond has a face value of $1,000, an 8.00% semiannual coupon rate, and is selling for 99.10% of par. The market risk premium is 9.79%, T-Bills are yielding 3.21%, and the tax rate is 26%. What discount rate should the firm apply to a new project's cash flows if the project has the same risk as the company's typical project?

Group of answer choices

Answer 1

The discount rate that should be applied to a new project's cash flows is the Weighted Average Cost of Capital (WACC). To calculate WACC, you need to first calculate the cost of debt. This is done by taking the face value of the bonds ($1000) multiplied by the coupon rate (8%) multiplied by (1 - the tax rate (26%)), which equals 5.92%. The cost of debt is then calculated by taking the market value of the debt (6,380 x $1,000 x 99.1%) and dividing this by the total market value of the debt plus the market value of the equity (6,380 x $1,000 x 99.1% + 76,650 x $50 + 14,250 x $80), which equals 5.22%.

Next, you need to calculate the cost of equity using the Capital Asset Pricing Model (CAPM). This is done by taking the risk-free rate (3.21%) plus the market risk premium (9.79%) multiplied by the firm's beta (1.47), which equals 17.18%.

The WACC is then calculated by taking the cost of equity multiplied by the proportion of equity (76,650 x $50 + 14,250 x $80 divided by the total market value of the debt plus the market value of the equity) plus the cost of debt multiplied by the proportion of debt (6,380 x $1,000