In: Finance
Filer Mining Corporation has eight million shares of common stock outstanding, 400,000 shares of 4 percent preferred stock outstanding, and 150,000 7 percent semiannual bonds outstanding, par value $1,000 each. The common stock currently sells for $45 per share and has a beta of 0.90, the preferred stock currently sells for $70 per share, and the bonds have 15 years to maturity and sell for 90 percent of par. The market risk premium is 9 percent, the risk-free rate is 5 percent, and Filer Mining’s tax rate is 34 percent.
a. What are the firm’s market value capital structure weights?
b. If Filer 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? (The YTM on the debt is either 6.17% or 8.17%).
Filer Mining Corporation has eight million shares of common stock outstanding, 400,000 shares of 4 percent preferred stock outstanding, and 150,000 7 percent semiannual bonds outstanding, par value $1,000 each. The common stock currently sells for $45 per share and has a beta of 0.90, the preferred stock currently sells for $70 per share, and the bonds have 15 years to maturity and sell for 90 percent of par. The market risk premium is 9 percent, the risk-free rate is 5 percent, and Filer Mining’s tax rate is 34 percent.
a. What are the firm’s market value capital structure weights?
Common stock
8 million shares, currently selling for $45
Market value of Common stock = 8000000 * 45 = $ 360000000
Preferred stock
400000 shares, currently sells for $ 70
Market value of preferred stock = 400000 * 70 = $ 28000000
Debt
150000 bonds, 1000 par value. Currently traded 90% of par = 1000 * 90% = 900
Market value of debt = 150000 * 900 = 135000000
Total market value = 360000000 + 28000000 + 135000000 = 523000000 = 100%
Weight of Common stock = 360000000 / 523000000 = 0.6883 = 68.83%
Weight of Preferred stock = 28000000 / 523000000 = 0.0535 = 5.36%
Weight of Debt = 135000000 / 523000000 = 0.2581 = 25.81%
b. If Filer 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?
Here the firm should use the company Weighted average cost of capital. Of 10.71%
Calculation
WACC = ( cost of equity * weight ) + ( cost of preferred stock * weight ) + ( cost of debt * weight)
For calculating first we need to calculate each components cost.
Cost of equity = Here the data are given, based on those data we can calculate cost of equity under CAPM
Under CAPM (capital assets pricing model)
Cost of equity = Rf + beta * ( Km - Rf )
Where,
Rf = risk-free rate is 5 percent
beta = 0.90
market risk premium is = ( Km - Rf ) = 9%
Cost of equity = 5% + 0.90 * 9 = 5 + 8.1 = 13.10%
Cost of preferred stock = D / M
Where,
D = dividend = par value * rate = assume that par value is 100 * 4% = 4
M = market current price = 70
Cost of preferred stock = 4 / 70 = 0.0571 = 5.71%
After tax cost of debt = Before tax cost of debt - tax rate
Before tax cost of debt = yield to maturity(YTM)
The formula for YTM = ( C + ( ( P - M ) / n ) ) / ( ( p + m ) / 2 )
Where,
C (coupon interest) = Par value * Coupon rate = *$1000 * 7% = 70
P (Par Value ) = $1000
M (Market Price) = 900
n (years to maturity) = 15 years
By applying values into the formula we get,
YTM = ( 70 + ( ( $1000 - 900 ) / 15 ) ) / ( ( $1000 + 900 ) / 2 )
YTM = ( 70 + 100 / 15 ) / ( 1900 / 2 )
YTM = ( 70 + 6.667 ) / 980
YTM = 76.667 / 950 = 0.0807 = 8.07% in the question 8.17% difference is from estimation. 8.17% is the correct (we can see it using the online ytm calculator) so, no problem
So the cost of debt before tax = 8.17%
After tax cost of debt = before tax cost of debt * ( 1 - tax rate )
Where,
cost of debt before tax = 8.17%
Tax rate = 34%
After tax cost of debt = 8.17% ( 1 - 34% ) = 5.39%
Next we calculate WACC
WACC = ( 13.10 * 68.83% ) + ( 5.71 * 5.36% ) + ( 5.39% * 25.81% )
WACC = 9.0167 + 0.306 + 1.39 = 10.71%