Titan Mining Corporation has 8.2 million shares of common stock outstanding, 260

ID: 2718482 • Letter: T

Question

Titan Mining Corporation has 8.2 million shares of common stock outstanding, 260,000 shares of 4 percent preferred stock outstanding, and 140,000 7 percent semiannual bonds outstanding, par value $1,000 each. The common stock currently sells for $30 per share and has a beta of 1.10, the preferred stock currently sells for $80 per share, and the bonds have 10 years to maturity and sell for 110 percent of par. The market risk premium is 7 percent, T-bills are yielding 3 percent, and the company’s tax rate is 38 percent.

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.)

If the company 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 percent rounded to 2 decimal places, e.g., 32.16.)

Explanation / Answer

Weighted Average Cost of Capital (WACC) is the overall costs of capital. WACC is based on your current capital structure. Market values are used to assign weights to different components of capital. It should be noted that market weights are preferred over book value weights since market values more closely reflect how you raise your capital. Market weights are calculated by simply dividing the market value for each component by the sum of market values for all components. The following example illustrates how you calculate weighted average cost of capital.

Current Capital Structure consists three components: Long-term Debt (10 year A Bonds) with a book value of $ 400,000 and a cost of capital of 6.0%. Common Stock with a book value of $ 200,000 and a cost of capital of 18.0%. Retained Earnings with a book value of $ 50,000 and a cost of capital of 16.0%.

• Determine Market Values for Capital Components. 10-Year grade A bonds are selling for $ 1,150 per bond and the common stock is selling for $ 40.00 per share. Assume we have 500 bonds outstanding and 15,000 shares of stock outstanding. Market Value for Debt is $ 575,000 ($ 1,150 x 500) and Market Value for Stock is $ 600,000 ($ 40.00 x 15,000).

• Allocate the Equity Market Value between Common Stock and Retained Earnings based on book values. Common Stock = $ 480,000 ($ 200,000 / $ 250,000 x $ 600,000). Retained Earnings = $ 120,000 ($ 50,000 / $ 250,000 x $ 600,000).

• Calculate the WACC using market weights:

The Debt (Bonds) has a market weight of .49 ($ 575,000 / $ 1,175,000) x .06 cost of capital = .029. Stock has a market weight of .41 ($ 480,000 / $ 1,175,000) x .18 cost of capital = .074. Finally, Retained Earnings has a market weight of .10 ($ 120,000 / $ 1,175,000) x .16 cost of capital = .016. This gives us a Weighted Average Cost of Capital of .119 or 11.9% (.029 + .074 + .016).

a. Market Value weight

Debt 1100 * 140000=15400000 =5.84

Preferred stock 80 *260000 =2080000 =0.8

Equity 30 * 8200000=246000000=93.365

b Weighted average cost of capital =market weight * cost of capital

Cost of equity

=Risk free rate + Beta (Market price-Risk free rate)

=.03 + 1.10*.07=0.03 +0.077=0.107

Cost of debt

=Risk free rate (1-Tax rate)

=.07(1.38)=2.66

Cost of preferred equity

.04

Weighted cost=93.36*0.107 + 5.84 * 2.66 + .8 * .04=25.84 %

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Titan Mining Corporation has 8.2 million shares of common stock outstanding and

Titan Mining Corporation has 8.2 million shares of common stock outstanding, 260

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Titan Mining Corporation has 8.2 million shares of common stock outstanding, 260

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