Question

Hankins Corporation has 8.3 million shares of common stock outstanding, 305,000 shares of 3.9 percent preferred stock outstanding, par value of $100; and 190,000 bonds with a semiannual coupon rate of 5.2 percent outstanding, par value $2,000 each. The common stock currently sells for $56 per share and has a beta of 1.20, the preferred stock has a par value of $100 and currently sells for $100 per share, and the bonds have 19 years to maturity and sell for 108 percent of par. The market risk premium is 6.8 percent, T-bills are yielding 3.2 percent, and the company’s tax rate is 25 percent.

a.	What is the firm’s market value capital structure? (Do not round intermediate calculations and round your answers to 4 decimal places, e.g., .1616.)
b.	If the company 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 percent rounded to 2 decimal places, e.g., 32.16.)

Answer 1

Hankins Corporation:

Calculation of firm's market value

Firm's market value = Market value of equity + Market value of debt

Firm's market value = $495.30 + 504.1758

Firm's market value = $999.4758 millions

Market Value of equity

1) Market value of 8.3 millions common stock = number of shares x current market price

Market value of 8.3 millions common stock = 8300000 x 56

Market value of 8.3 millions common stock = $464800000 or $464.80 millions

2) Market value 305000 shares of preferred stock = number of shares x current market price

Market value 305000 shares of preferred stock = 305000 x 100

Market value 305000 shares of preferred stock = $30500000 0r $30.5 millions

Total market value of equity = 464.80 + 30.5 = $495.30 millions

Market Value of bonds

First we need to calculate the fair price of bond:

Given:

Par value of bond = $2000

coupon rate = 5.2% semiannually or 5.2/2 = 2.6%

yield to maturity = 3.2% or 3.2/2 = 1.6% (assumed yield to maturity same as treasury bills yield of 3.2% as it is a risk free rate)

maturity value = $2160 (2000 x 1.08) (maturity is 108% of par value)

maturity years = 38 (19 x 2)

Fair price = Interest / (1 + kd)1 + Interest / (1 + kd)2 + ...........................................Maturity value / (1 + kd)38

Fair price = 52 / (1 + 0.016)1 + 52 / (1 + 0.016)2 + ..............................................2160 / (1 + 0.016)38

Fair price = (52 x 28.3084 + 2160 x 0.5470)

Fair price = (1472.0368 + 1181.52)

Fair price = $2653.5568

Hence, Fair price of bond is $2653.5568.

Market value of bond = fair price of bond x number of bonds

Market value of bond = $2653.5568 x 190000

Market value of bond = $504175792 or $504.1758 millions

b) Calculation of firm's weighted average cost of capital

1) Calculation of cost of debt

cost of debt = Interest (1 - tax rate)

cost of debt = 3.2 (1 - 0.25)

cost of debt = 2.4%

2) Calculation of cost of equity

cost of equity can found out using the capital asset pricing model which is as under:

CAPM = Rf + Beta x market risk premium

where,

Rf = 3.2%

Beta = 1.20

market risk premium = 6.8%

CAPM = 3.2 + 1.2 x 6.8

CAPM = 11.36%

Hence, cost of equity is 11.36%.

WACC = cost of equity x weight of equity + cost of debt x weight of debt

WACC = 11.36 x 495.30 / 999.4758 + 2.4 x 504.1758 / 999.4758

WACC = 5.63% + 1.21%

WACC = 6.84%

Comment: If the company is evaluating a new investment project that has the same risk as the firm's typical project, Hankins Corporation can use a discount rate of 6.84% to discount its cashflows.