Organic Produce Corporation has 6.3 million shares of common stock outstanding,

Question

Organic Produce Corporation has 6.3 million shares of common stock outstanding, 350,000 shares of 5.8 percent preferred stock outstanding, and 150,000 of 7.1 percent semiannual bonds outstanding, par value $1,000 each. The common stock currently sells for $74 per share and has a beta of 1.09, the preferred stock currently sells for $107 per share, and the bonds have 20 years to maturity and sell for 109 percent of par. The market risk premium is 6.8 percent, T-bills are yielding 4.3 percent, and the firm's tax rate is 34 percent.

a. What is the firm's market value capital structure?

b. If the firm 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?

Explanation / Answer

Hi,

Please find the answer as follows:

Market Value of Equity = Number of Outstanding Shares*Current Selling Price = 6300000*74 = 466200000

Market Value of Debt = Number of Bonds*Current Selling Price = 150000*1000*109% = 163500000

Market Value of Preferred Stock = Number of Outstanding Shares*Current Selling Price = 350000*107 = 37450000

Total Market Value = 466200000 + 163500000 + 37450000 = 667150000

Weight of Equity in Capital Structure (E/V) = 466200000/ 667150000 = .698

Weight of Debt in Capital Structure (D/V) = 163500000/667150000 = .245

Weight of Preferred Stock in Capital Structure (P/V) = 37450000/667150000 = .056

Part B:

Cost of Equity = Risk Free Rate + Beta*Market Risk Premium = 4.3 + 1.09*6.8 = 11.712%

Cost of Preferred Stock = Return/Current Seling Price = (5.8%*100)/107*100 = 5.421%

Cost of Debt

Nper = 20*2 = 40

PMT = 1000*.071*1/2 = 35.5

FV = 1000

PV = 1000*109 = 1090

Rate = ?

After Tax Cost of Debt = Rate(Nper,PMT,PV,FV) = Rate(40,30.5,-1090,1000)*2*(1-.34) = 3.538%

WACC = After Tax Cost of Debt*Weight of Debt + Cost of Preferred Stock*Weight of Preferred Stock + Cost of Equity*Weight of Equity

WACC = 3.538*.245 + 5.421*.056 + 11.712*.698 = 9.345% or 9.35%

Answer for Part 2 is 9.345% or 9.35%.

Thanks.

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