Question

General Electric has 10 million shares of common stock with a book value of $1 per share and a current market price of $25 per share. The company’s beta is 1, the risk free rate is 3% and the market rate is 9%. The firm’s outstanding bonds have a total face value of $75 million, a maturity of 10 years, a 4% annual coupon, and are selling currently for 101% of par value. The marginal tax rate is 35%. What discount rate should General Electric use to evaluate its projects? (You MUST show all your work) 21. What is the weight of equity? A) 57.3% B) 42.7% C) 76.7% D) 23.3% 22. What is the weight of debt? A) 57.3% B) 42.7% C) 76.7% D) 23.3% 23. What is the rate of equity? A) 9% B) 3% C) 12% D) 4.5% 24. What is the rate of debt? A) 4.0% B) 3.8% C) 1.9% D) 7.6% 25. What is the discount rate for the firm? A) 7.5% B) 4.1% C) 3.8% D) 2.8%

Answer 1

MV of equity=Price of equity*number of shares outstanding

MV of equity=25*10000000

=250000000

MV of Bond=Par value*bonds outstanding*%age of par

MV of Bond=1000*75000*1.01

=75750000

MV of firm = MV of Equity + MV of Bond

=250000000+75750000

=325750000

Weight of equity = MV of Equity/MV of firm

Weight of equity = 250000000/325750000

W(E)=0.7675

Weight of debt = MV of Bond/MV of firm

Weight of debt = 75750000/325750000

W(D)=0.2325

Cost of equity

As per CAPM

Cost of equity = risk-free rate + beta * (expected return on the market - risk-free rate)

Cost of equity% = 3 + 1 * (9 - 3)

Cost of equity% = 9

Cost of debt

K = N

Bond Price =∑ [(Annual Coupon)/(1 + YTM)^k]     +   Par value/(1 + YTM)^N

k=1

K =10

1010 =∑ [(4*1000/100)/(1 + YTM/100)^k]     +   1000/(1 + YTM/100)^10

k=1

YTM = 3.8774600051

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 3.8774600051*(1-0.35)

= 2.520349003315

WACC=after tax cost of debt*W(D)+cost of equity*W(E)

WACC=2.52*0.2325+9*0.7675

WACC =7.49%

weight of equity = 76.7%

weight of debt = 23.3%

rate of equity = 9%

rate of debt = 3.8%

discount rate for the firm = 7.5%