Question

Titan Mining Corporation has 8.5 million shares of common stock outstanding and 250,000 8 percent annual coupon bonds outstanding, par value $1,000 each. The common stock currently sells for $34 per share and has a beta of 1.20, and the bonds have 15 years to maturity and sell for 93 percent of par. The market risk premium is 7 percent, T-bills are yielding 5 percent, and Titan Mining’s tax rate is 40 percent.

1. What is the firm’s market value capital structure? (10 points)
2. If Titan 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? (10 points)

Answer 1

a

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

MV of equity=34*8500000

=289000000

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

MV of Bond=1000*250000*0.93

=232500000

MV of firm = MV of Equity + MV of Bond

=289000000+232500000

=521500000

Weight of equity = MV of Equity/MV of firm

Weight of equity = 289000000/521500000

W(E)=0.5542

Weight of debt = MV of Bond/MV of firm

Weight of debt = 232500000/521500000

W(D)=0.4458

b

Cost of equity

As per CAPM

Cost of equity = risk-free rate + beta * (Market risk premium)

Cost of equity% = 5 + 1.2 * (7)

Cost of equity% = 13.4

Cost of debt

K = N

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

k=1

K =15

930 =∑ [(8*1000/100)/(1 + YTM/100)^k]     +   1000/(1 + YTM/100)^15

k=1

YTM = 8.8613149767

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

After tax cost of debt = 8.8613149767*(1-0.4)

= 5.31678898602

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

WACC=5.32*0.4458+13.4*0.5542

WACC% = 9.8