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A company has 4.3 million shares of common stock outstanding and 85,000 bonds outstanding, par value...

A company has 4.3 million shares of common stock outstanding and 85,000 bonds outstanding, par value of $1,000 each. Each bond has a 6.8 percent annual coupon rate and the bonds have 23 years to maturity and is now selling at $789.23. (Based on the current price, its YTM is 9%) Coupon is paid annually. The common stock currently sells for $58.00 per share and has a beta of 0.90.  The market risk premium is 7 percent and Treasury bills are yielding 5 percent and the company’s tax rate is 35 percent.

a. What are the weight of debt component (D/V) in the firm’s capital structure?

b. What is the weight of equity component (E/V) in the firm’s capital structure?

c.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?

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Expert Solution

Answer :

Market Value of Debt = Number of Bond * Current Market Price of Bond

= 85000 * 789.23

= 67,084,550

Market Value of Equity = Number of shares * Current Market Price of share

= 4,300,000 * 58

= 249,400,000

Total Market Value = Market Value of Debt + Market Value of Equity

= 67,084,550 + 249,400,000

= 316,484,550

a. Weight of debt component (D/V) in the firm’s capital structure =  Market Value of Debt / Total Market Value

= 67,084,550 / 316,484,550

=0.21196785119 or 0.2120

b. Weight of equity component (E/V) in the firm’s capital structure = Market Value of Equity / Total Market Value

= 249,400,000 / 316,484,550

=0.788031488 or 0.7880

(c.) If the company is evaluating a new investment project that has the same risk as the firm’s typical project, the firm should use Weighted Average Cost of Capital to discount the project’s cash flows:

WACC = (Cost of equity * Weight of equity) + (cost of debt after tax * Weight of debt )

Cost of Equity = Risk Free rate + ( Beta * Market Risk Premium)

= 5% + (0.90 * 7%)

= 11.30%

WACC = (Cost of equity * Weight of equity) + (cost of debt after tax * Weight of debt )

= (11.30 * 0.788031488 ) + { [ (9% * (1- 0.35) ] * 0.21196785119  }

= 8.9047558144 % + { 5.85% * 0.21196785119 }

= 8.9047558144% + 1.24001192946

= 10.1447677438 or 10.14%

  

jeff jeffy answered 1 year ago
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