Organic Produce Corporation has 7.9 million shares of common stock outstanding,

Question

Organic Produce Corporation has 7.9 million shares of common stock outstanding, 540,000 shares of 7.4 percent preferred stock outstanding, and 179,000 of 8.6 percent semiannual bonds outstanding, par value $1,000 each. The common stock currently sells for $64.40 per share and has a beta of 1.24, the preferred stock currently sells for $107.60 per share, and the bonds have 13 years to maturity and sell for 94 percent of par. The market risk premium is 7 percent, T-bills are yielding 5.7 percent, and the firm’s tax rate is 35 percent.

Required: (a) What is the firm's market value capital structure?
Market value weight of debt:
Market value weight of preferred stock:
Market value weight of equity:

(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?
Weighted average cost of capital %:

Explanation / Answer

# Amount per unit Market Value Weight Cost WACC a b c = a*b d = c / $735,124,000 e d*e Debt 179000 $940.00 $168,260,000.00 22.89% 6.12% 1.40% Preferred Stock 540000 $107.60 $58,104,000.00 7.90% 6.88% 0.54% Common Stock 7900000 $64.40 $508,760,000.00 69.21% 14.38% 9.95% Market Value of Capital Structure $735,124,000.00 11.90% Cost of Equity As per CAPM, Re = Risk Free rate of return + Market Risk Premium *Beta = 5.7% + 7% * 1.24 = 14.38% Cost of Preferred Stock = 7.4 / 107.60 = 6.88% Price of Bond = [C [1 - (1+r)^-2t] / r] + [F / (1+r)^2t] C - Coupon Payment @ 8.6% semi annually = $43 each period r - YTM = ? F - Face Value = $1000 t - Years = 13 Price = $940 940 = [43 * [1 - (1+r^-26)/r] + [1000 / 1+r^26] Since price of bond is less than face value yield is more than coupon rate At r = 10% Price = [43 * [1 - (1.05^-26)/0.05] + [1000 / 1.05^26] = 618.133 + 281.2407 = 899.37 At r = 9% Price = [43 * [1 - (1.045^-26)/0.045] + [1000 / 1.045^26] = 651.3043 + 318.4025 = 969.71 By Interpolating, YTM = 2* [4.5% + {(940 - 969.71) / (899.37 - 969.71)}*(5-4.5)%] = 2* [4.5% + 29.71/70.33 * 0.5%] = 2 * (4.5% + 0.21%) = 9.42% After tax cost of debt = 9.42% * (1-0.35) = 6.12% WACC - 11.90% (as calculated above) This rate should be used to evaluate projects for discounting cash flows

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