WACC: Outshore Mining has 8.5 million shares of common stock outstanding and 250
ID: 2763255 • Letter: W
Question
WACC:
Outshore Mining 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 Outshore Mining's tax rate is 40 percent.
What is the firm’s market value capital structure?
If Outshore 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?
Explanation / Answer
Market Value of debt = 250,000 *1000 *0.93 = 232,500,000
Market Value of equity = 8,500,000 * 34 = 289,000,000
So total value = 232,500,000 +289,000,000 = 521,500,000
Hence weight of debt = Wd = 232.5/521.5 = 0.4458
Weight of equity = We = 1-0.4458 = 0.5542
Capital structure of Outshore Mining is 44.58% debt and 55.42% equity
Cost of equity is given by CAPM as in Re = Rf + beta*Market risk premium= 5 + 1.2*7 = 13.4%
Pretax cost of debt = rate(nper,pmt,pv,fv) in excel where nper =15, pmt = 8% of 1000 =80, pv = 93% of 1000 =930 and fv =1000.
Pretax cost of debt = rate(nper,pmt,pv,fv) =rate(15,80,-930,1000) = 8.8613%
Post tax cost of debt = Rd = Pretax cost*(1-tax rate) = 8.8613*(1-0.4) = 5.32%
The discount rate of the firm = WACC = We*Re + Wd* Rd = 0.5542*13.4 + 0.4458*5.32 = 9.7979% = 9.80%
The discount rate the firm should use is 9.80%
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