Question

Show all your work (use of formula, etc.) in solving the problems. You still need to show your work even if you use the financial calculator to get the answers. (Please show all work and do not use excel)

3. Forrest Corporation has 500,000 shares of common stock, 10,000 shares of preferred stock, and 5,000 bonds with 8 percent (coupon) outstanding. The common stock currently sells for $25 per share and has a beta of 0.95. Preferred stocks pay a dividend of $8 per share and currently sell for $98 with a floatation cost of $2 per share. The bonds have par value of $1,000, 20 years to maturity, currently sell for 102.5 percent of par, and the coupons are paid semiannually. The bond’s floatation cost is 1% of the current market price. The expected return on market portfolio is 9 percent, T-bills are yielding 2 percent, and the tax rate is 35 percent. What is the firm’s market value capital structure? If Forrest 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?

Answer 1

Firm's Capital structure using market value would be sum of three things-

1) Market value of equity shares

2) Market value od debt

3) Market value of preferred stock

First arrive at the market value of equity using market price and number of equity shares. Its given that current market price of common stock is 25$ and the company has 500,000 shares, therefore total market value of equity shares is 12500,000$.

Market value of preference shares would be (market price less floatation cost) multiplied by number of preference shares. Market price is 98$ while number of preference shares is 10,000 and flotation cost is 2$. Therefore market capital of preference shares would be 960,000$ ((98-2)*10000).

Market value of debt is 5000 bonds* 1014.75$ (1000*102.5%-1% of 1025)= 5073750$

Therfore total capital structure based on market capital would be-

1)Common stock-  12500,000$. Weight- 0.67 (12500000/18533750)

2)Preferred stock- 960,000$. Weight- 0.05 (960,000/18533750)

3) Bonds- 5073750$ Weight- 0.28 (5073750/18533750)

Total- 18533750$

To evaluate a new project it should use Weighted average cost of capital of its source of capital.

WACC= Weight of equity*Cost of equity+ Weight of preferred stock* Cost of preferred stock+ Weigt of Bond*.Cost of bond

cost of equity using CAPM- Risk free rate+ Beta (Market return- risk free rate)

or cost of equity- 2%+ 0.95(9%-2%) =8.65%

Cost of preference shares- Dividends/ Market price -floatation cost

or 8$/ (98-2)= 8.33%

Cost of bond using financial calcualtor where PV is 1025$, N= 40 (20 years and twice a year), PMT= 80$ (1000*8%)

Therefore YTM ir I/Y would be 7.79%. It should be taken net of taxes therfore net cost of bond would be 7.79%*(1-35%)=5.07%

Therfore WACC- 0.67*8.65%+ 0.05*8.33%+ 0.28*5.07%= 6.23%

This rate should be used to evaluate project cash flows.