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

a. The firm's market value capital structure is $102 million. b. The firm should discount the project's cash flows at a rate of 9%.

Step-by-step explanation:

a. To calculate the firm's market value capital structure, we need to determine the market value of each component of the capital structure and then add them together. The market value of the common stock is calculated by multiplying the number of shares outstanding (6.3 million) by the current stock price ($74 per share).

The market value of the preferred stock is calculated by multiplying the number of shares outstanding (350,000) by the current stock price ($107 per share). The market value of the bonds is calculated by multiplying the number of bonds outstanding (150,000) by the bond price (109% of par value). Then, we add the market values of each component to get the total market value capital structure.

b. To discount the cash flows of a new investment project, the firm should use the firm's cost of financial capital. This is the rate that the firm needs to earn on the investment to satisfy its investors. In this case, the cost of financial capital is given as 9%. Therefore, the firm should discount the project's cash flows at a rate of 9%.

Answer 2

(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%

Step-by-step 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%