Organic Produce Corporation has 7.6 million shares of common stock outstanding,

Question

Organic Produce Corporation has 7.6 million shares of common stock outstanding, 510,000 shares of 7.1 percent preferred stock outstanding, and 176,000 of 8.3 percent semiannual bonds outstanding, par value $1,000 each. The common stock currently sells for $64.10 per share and has a beta of 1.21, the preferred stock currently sells for $107.90 per share, and the bonds have 16 years to maturity and sell for 95.5 percent of par. The market risk premium is 6.85 percent, T-bills are yielding 5.55 percent, and the firm’s tax rate is 30 percent.

(a) What is the firm's market value capital structure? (Do not round intermediate calculations. Round your answers to 4 decimal places (e.g., 32.1616).)

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? (Do not round intermediate calculations. Enter your answer as a percentage rounded to 2 decimal places (e.g., 32.16).)

Weighted average cost of capital:

Explanation / Answer

First let us calculate Cost of capital for each source of capital

Cost of equity, Ke= Rf +Beta(Market risk premium)

as we know Risk free rate,Rf= T-bill rate= 5.55%; Beta= 1.21 & Market risk premium= 6.85%

So Cost of equity, Ke= 5.55 + 1.21*6.85%= 13.84%

Cost of Debt

Interest Rate= 8.3%; Years to maturity, t= 16 years ; As bonds are semiannual so                                    effective interest rate, = 8.3%/2= 4.15%; No. of payments, n= 16*2= 32.

Face Value of bonds= $1000; Market value = 95.5% of Face value= $955.

Let Yield to maturity(pretax cost of debt) be r

Market price of Bond = (Coupon Payment ×1(1+r)-n)/r+Face Value of Debt/(1+r)n

where coupon payment= (Rate of Bond/ No. of Payments per year)*Face Value of Debt

= 4.15*1000= $ 41.5

So by putting the respective values in market price of bond equation we can calculate r which comes to be

r= 0.0883= 8.83%

Post tax Cost of Debt, Kd= r(1-T) where T-tax rate= 30% so Kd= 6.18%

Cost of Preferred Stock, Kp = 7.1%

Part A

Now calculating weight of each type of capital

Value of Equity, E= No. of shares outstanding * price of share = 7,600,000 * 64.10= $ 487,160,000/-

Value of Preferred Stock, P= No. of shares outstanding * price of share= 510,000 * 107.90 = $ 55,029,000/-

Value of Debt, D= No. of bonds * market price of bond= 176,000* $955 = $ 168,080,000/-

Net Value of Company , V= E+P+D= $ 710,269,000

Weight of equity, We= E/V=0.6859

Weight of preferred stock, Wp= P/V=0.0775

Weight of debt, Wd= D/V= 0.2366

Part B

The firm should use Weighted average Cost of Capital(WACC) to discount cash flows of its projects.

WACC= We.Ke + Wp.Kp + Wd.Kd = 11.65%

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