Question

You have been asked to estimate the appropriate discount rate to use in the evaluation of a new line of business. You have determined the market value of the firm’s target capital structure as follows:

Source of Capital	Market Value
Bonds	350,000
Preferred Stock	200,000
Common Stock	450,000

To finance the new project, the company will sell:

• 12-year bonds with a $1,000 par value paying 8% per year (paid semiannually) at the market price of $980.
• Preferred stock paying a $2.50 dividend and selling for $25.
• The firm’s common stock paid $3 dividend last year and expects dividends to continue growing at a rate of 6% per year indefinitely. The common stock is selling at $42 per share.

The firm’s marginal tax rate is 30%.

1. Estimate the discount rate that the firm needs to use to evaluate the project. (5 points)
2. In the analysis done so far we have not considered the effects of the floatation costs. Assume now that the company is raising a total of $1,000,000 using the above financing mix. New debt financing will require that the firm pays 100 basis points (i.e. 1%) in issue costs, the sale of preferred stock will require the firm to pay 250 basis points in flotation costs, and the common stock issue will require flotation costs of 500 basis points.
3. a. Estimate the total flotation costs the firm will incur to raise the needed $1 million. (2 points)

1. b. How should the flotation costs be incorporated into the analysis of the $1 million investment the firm plans to make? (1 point)

Answer 1