Question

Raymond Mining Corporation has 9.2 million shares of common stock outstanding, 360,000 shares of 5% $100 par value preferred stock outstanding, and 157,000 7.50% semiannual bonds outstanding, par value $1,000 each. The common stock currently sells for $40 per share and has a beta of 1.60, the preferred stock currently sells for $96 per share, and the bonds have 15 years to maturity and sell for 111% of par. The market risk premium is 8.0%, T-bills are yielding 5%, and Raymond Mining’s tax is 40%.

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

	Market value
Debt	$
Equity	$
Preferred stock	$

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.)

Discount rate              %

Answer 1

Requirement (a) – Firm’s Market Value Capital Structure

Capital Components	Market value
Debt	$174,270,000
Equity	$368,000,000
Preferred Stock	$34,560,000

Requirement (b) – Discount Rate to be used by the firm to discount the project's cash flows

Calculations

Market Value of Debt = $174,270,000 [157,000 Bonds x ($1,000 x 110%)]

Market Value of Equity = $368,000,000 [9,200,000 shares x $42 per share]

Market Value of Preferred Stock = $34,560,000 [360,000 shares x $96 per share]

Total Market Value = $576,830,000

After-tax Cost of Debt

The After-Tax Cost of Debt is the After-Tax Yield to maturity of (YTM) of the Bond and is calculated using financial calculator as follows (Normally, the YTM is calculated either using EXCEL Functions or by using Financial Calculator)

Variables	Financial Calculator Keys	Figures
Par Value/Face Value of the Bond [$1,000]	FV	1,000
Coupon Amount [$1,000 x 7.50% x ½]	PMT	37.50
Market Interest Rate or Yield to maturity on the Bond	1/Y	?
Maturity Period/Time to Maturity [15 Years x 2]	N	30
Bond Price [-$1,000 x 111%]	PV	-1,110

We need to set the above figures into the financial calculator to find out the Yield to Maturity of the Bond. After entering the above keys in the financial calculator, we get semi-annual yield to maturity (YTM) on the bond = 3.175%.

The semi-annual Yield to maturity = 3.175%.

Therefore, the annual Yield to Maturity of the Bond = 6.35% [3.175% x 2]

The firm’s after-tax cost of debt on the Bond is the after-tax Yield to maturity (YTM)

The After-tax cost of debt = Yield to maturity on the bond x (1 – Tax Rate)

= 6.35% x (1 – 0.40)

= 6.35% x 0.60

= 3.81%

Cost of Equity

As per CAPM Approach, the Cost of Equity = Risk-free Rate + [Beta x Market Risk Premium]

= Rf + [B x Risk Premium]

= 5.00% + [1.60 x 8.00%]

= 5.00% + 12.80%

= 17.80%

Cost of Preferred Stock

Cost of Preferred Stock = [Annual Preferred Dividend / Selling Price] x 100

= [($100 x 5.00%) / $96] x 100

= [$5.00 / $96.00] x 100

= 5.21%

Discount Rate to be used by the firm to discount the project's cash flows

Therefore, Discount Rate = [After Tax Cost of Debt x Weight of Debt] + [Cost of Preferred stock x Weight of preferred stock] + [Cost of equity x Weight of Equity

= [3.81% x ($174,270,000 / $576,830,000)] + [5.21% x ($34,560,000 / $576,830,000)] + [17.80% x ($368,000,000 / $576,830,000)]

= [3.81% x 0.3021] + [17.80% x 0.6380] + [5.21% x 0.0599]

= 1.151% + 11.356% + 0.312%

= 12.819%

“Hence, the Discount Rate to be used by the firm to discount the project's cash flows will be 12.819%”