Question

Raymond Mining Corporation has 8.3 million shares of common stock outstanding, 270,000 shares of 5% $100 par value preferred stock outstanding, and 139,000 7.50% semiannual bonds outstanding, par value $1,000 each. The common stock currently sells for $31 per share and has a beta of 1.15, the preferred stock currently sells for $93 per share, and the bonds have 15 years to maturity and sell for 112% of par. The market risk premium is 7.1%, T-bills are yielding 4%, and Raymond Mining’s tax is 30%.

a. What is the firm’s market value capital structure? (Enter your answers in whole dollars.)

b. If Raymond Mining 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? (Do not round intermediate calculations. Enter your answer as a percentage rounded to 3 decimal places.)

Answer 1

Ans.

Calculation of the market value of company's bond, common stock, and preferred stock:

Market value of debt=Total bond outstanding∗Market price

=139,000∗(1,000∗1.12)=139,000∗1,120=155,680,000

The market value of the firm's debt is $155,680,000

Market value of common stock=Total common stock outstanding∗Common stock share price

=8,300,000∗31=257,300,000

The market value of the firm's common stock is $257,300,000

Market value of preferred stock=Total preferred stock outstanding∗Preferred stock share price

=270,000∗93=25,110,000

The market value of the firm's preferred stock is $25,110,000

The market value of the firm's capital structure is as follows:

Market value=Bond market value+Common stock market value+Preferred stock market value

=155,680,000+257,300,000+25,110,000 = $ 438,090,000

The market value of the firm's capital structure is $ 438,090,000

b)

Bond yield to maturity

YTM= C +(F-P)/n /(F+P /2) * 2

where:

C=coupon payment = 37.5

F=face value = 1000

P=market price = 1120

n=number of periods

Bond's Coupon Amount = Coupon Rate * Face Value / No. of Payments

= 0.075* 1000/2 = 37.5

Yield to Maturity (YTM) is calculated as follows:

[37.5 + (1000-1120)/30(1000+1120)/2 ] * 2 =(37.5 -4)/1060 * 2 = 0.063207 or 6.32%

After tax Cost of debt = 6.32% (1-0.3) = 4.4245% or 4.42%

Cost of Equity

Re = Rf + Beta * (Rm - Rf)

where:

Re = Cost of Equity

Rf=risk free rate =4%

Beta =1.15

Rm - Rf = Market Risk Premium = 7.1%

Re = 4% + 1.15 *(7.1% ) = 12.165%

Cost of Preferred Stock

Dividend/ Price = 5 /93 = 0.05376 or 5.38%

Now, the weighted average cost of capital is as follows

Weight of Debt =$155,680,000/$ 438,090,000 = 0.355

Weight of Equity=$257,300,000/$ 438,090,000 = 0.587

Weight of Preferred Stock =$25,110,000/$ 438,090,000 = 0.058

WACC = After tax cost of Debt * Weight of debt + Cost of Equity * Weight of Equity + Cost of Preferred Stock * Weight of Preferred stock

WACC = 4.42% * 0.355+ 12.165%* 0.587 + 5.38% * 0.058

WACC = 1.5691+ 7.1408% + 0.31204% = 9.02194% or 9.022 %

In discounting the project's cash flow, the firm should choose its weighted cost of capital of 9.022%.