Question

1) Empire Today Inc. has 10 million shares of common stock outstanding, 300,000 shares of 5% preferred stock outstanding, and 7 million of 6.7 percent semiannual bonds outstanding, par value $1,000 each. The common stock currently sells for $85 per share and has a beta of 1.15, the preferred stock currently sells for $103 per share, and the bonds have 20 years to maturity and sell for 93% of par. The market risk premium is 11 percent, T-bills are yielding 2.14 %, and the firm's tax rate is 25.7%.

a) Calculate market values of Empire’s common stock, preferred stock, and debt.

b) Calculate market value weights of Empire’s common stock, preferred stock, and debt, then explain your problem solving step-by-step.

c) Calculate costs of Empire’s common stock, preferred stock, and debt

d) Calculate the firm’s Weighted Average Cost of Capital

e) The CFO is assessing a potential project which will yield an IRR of 9.3%. The project has the firm level risk. Should the CFO accept the project?

Answer 1

a)

Market value of common stock = 10,000,000 * 85 = $850,000,000

Market value of bond = 7,000,000 * (0.93 * 1000) = $6,510,000,000

Market value of preferred stock = 300,000 * 103 = 30,900,000

b)

Total market value = 850,000,000 + 6,510,000,000 + 30,900,000 = 7,390,900,000

Weight of common stock = (850,000,000 / 7,390,900,000) = 0.115 or 11.50%

Weight of bond = (6,510,000,000 / 7,390,900,000) = 0.8808 or 88.08%

Weight of preferred stock = (30,900,000 / 7,390,900,000) = 0.0042 or 0.42%

c)

Cost of common stock = Risk free rate + beta (market risk premium)

Cost of common stock = 2.14% + 1.15 (11%)

Cost of common stock = 14.79%

Assuming face value of preferred stock is $100

Preferred dividend = 0.05 * 100 = 5

Cost of preferred dividend = (Preferred dividend / price) * 100

Cost of preferred dividend = (5 / 103) * 100

Cost of preferred dividend = 4.8544%

Coupon = (0.067 * 1000) / 2 = 33.5

Number of periods = 20 * 2 = 40

Price = 0.93 * 1000 = 93

before tax cost of debt = 7.3748%

Keys to use in a financial calculator: 2nd I/Y 2, FV 1000, PV -930, PMT 33.5, N 40, CPT I/Y

After tax cost of debt = 0.073748 (1 - 0.257)

After tax cost of debt = 0.05480 or 5.48%

d)

Weighted Average Cost of Capital = 0.115*0.1479 + 0.8808*0.05480 + 0.0042*0.048544

Weighted Average Cost of Capital = 0.017009 + 0.048268 + 0.000204

Weighted Average Cost of Capital = 0.0655 or 6.55%

e)

CFO should accept the project as IRR is greater than cost of capital.