Organic Produce Corporation has 8.9 million shares of common stock outstanding,

Question

Organic Produce Corporation has 8.9 million shares of common stock outstanding, 640,000 shares of 7.4 percent preferred stock outstanding, and 189,000 of 8.6 percent semiannual bonds outstanding, par value $1,000 each. The common stock currently sells for $65.40 per share and has a beta of 1.34, the preferred stock currently sells for $106.60 per share, and the bonds have 13 years to maturity and sell for 89 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.   

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

b) What is the firm's cost of each form of financing?

Aftertax cost of debt (%)

Cost of perferred stock (%)

Cost of equity (%)

c) 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?

Organic Produce Corporation has 8.9 million shares of common stock outstanding, 640,000 shares of 7.4 percent preferred stock outstanding, and 189,000 of 8.6 percent semiannual bonds outstanding, par value $1,000 each. The common stock currently sells for $65.40 per share and has a beta of 1.34, the preferred stock currently sells for $106.60 per share, and the bonds have 13 years to maturity and sell for 89 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.   

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) What is the firm's cost of each form of financing?

Aftertax cost of debt (%)

Cost of perferred stock (%)

Cost of equity (%)

c) 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

Answer:

b) Pre tax cost of debt is its YTM, which can be found using the "Rate" function in excel.

Rate(nper,pmt,pv,fv,0), i,e, nper = no of periods to maturity = 13*2(semi annual) = 26 periods

pmt = Semi annual coupon = $1,000*8.6%/2 = $43

PV = Market price = $1,000*89% = $890

FV = Maturity amount = $1,000, "0" for the end of period receipt of coupon

SO the YTM = Rate(nper,pmt,pv,fv,0) = Rate(26,43,-890,1000,0) = 5.07%

Annual YTM = 5.07% * 2 = 10.14%

After tax cost of debt = 10.14%(1-0.35) = 6.59%

Cost of perferred stock (%) = Preferred dividend/Market price of preferred stock = $100*7.4%/$106.6 = 6.94%

Cost of equity = Risk free rate+ Beta* Market risk premium = 5.7% + 1.34 *7% = 15.08%

c) Weighted average cost of capital:

a) Numbers Market Price Market Value Weight Debt 189000 890 168210000 20.55% Equity Shares 8900000 65.4 582060000 71.11% Preference Share 640000 106.6 68224000 8.34% Total MV: 818494000

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