Question

Filer Manufacturing has 8.3 million shares of common stock outstanding with book value of $4 per share. The firm just paid a $2 dividend per share and will not pay any dividend in the next five years, after which the firm starts to pay an annual dividend of $ 4 per share forever. The company also has a bond issue outstanding with a total face value of $70 million. Each bond has a face value of $1,000, a coupon rate of 7 percent and matures in 8 years. The current annual yield in the market for a bond with the same level of risk is 6%. The bond makes semiannual payments. The tax rate is 35 percent. The company’s common stock has a correlation of 0.77 with the market and a standard deviation of returns of 12.35%. The risk-free rate is 3.7 percent, the market risk premium is 7 percent, and the market has a standard deviation of returns of 8.25%. What opportunity cost of capital should the firm use in evaluating its typical projects?

Please answers with details.

Answer 1

1]	Beta of the stock = Correlation[market,stock]*SDstock/SD market = 0.77*12.35/8.25 =	1.15
2]	Cost of capital = risk free rate+beta*market risk premium = 3.7%+1.15*7% =	11.75%
	After tax cost of debt = 6%*(1-35%) =	3.90%
3]	Bond price = 1000/1.06^8+70*(1.06^8-1)/(0.06*1.06^8) =	$           1,062.10
	Stock price at t5 = 4/0.1175 =	$                 34.04
	Current stock price = 34.04/1.1175^5 =	$                 19.53
4]	CALCULATION OF WACC:
		Market Value [$ million]	Weight	Component Cost	WACC
	Common stock [8.3m*$19.53]	$            162.099	68.56%	11.75%	8.06%
	Debt [1062.10*70/1000]	$              74.347	31.44%	3.90%	1.23%
	Total	$            236.446	100.00%		9.28%
	WACC = 9.28%
5]	The opportunity cost to be used for evaluating its typical projects is the WACC; that is 9.28%.