Question

Ramblin Wreck is a firm specializing in engineering components. The firm is publicly traded and is considering the following project:

The project will last 5.00 years with an annual cash flow of $40.00 million. The project will require an initial investment of $140.00 million

The firm must determine the cost of capital to evaluate the project. (The project is within the firm’s normal activities)

Ramblin Wreck, Inc. Financial Data:

STOCK DATA:		BOND DATA:
Current Price Per Share	$29.00	Current Price Per Bond	$936.00
# of Shares	2.00 million	# of bonds	20,000.00
Book Value	$50 million	Annual Coupon Rate	8.00%
		Face Value Per Bond	$1,000
		Maturity	10 years

The risk free rate in the economy is currently 2.00%, while investors have a market risk premium of 8.00%. Ramblin Wreck, Inc. has a beta of 1.42. The tax rate is 36.00%.

a) What is the yield to maturity on Ramblin Wreck, Inc. bonds?

b) What is the cost of equity?

c) What is the weight in debt for the project?

Answer 1

a

K = N

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

k=1

K =10

936 =∑ [(8*1000/100)/(1 + YTM/100)^k]     +   1000/(1 + YTM/100)^10

k=1

YTM% = 9

b

As per CAPM

expected return = risk-free rate + beta * (Market risk premium)

Expected return% = 2 + 1.42 * (8)

Expected return% = 13.36

c

Total Firm value = price of Debt*Shares of Debt + price of Equity*Shares of Equity

=936*20000+29*2000000

=76720000

Weight of Debt = price of Debt*Shares of Debt/Total Firm Value

= 18720000/76720000

=0.244