Caterpillar Inc. has 8 million shares of common stock outstanding, and 1.5 milli
ID: 2733540 • Letter: C
Question
Caterpillar Inc. has 8 million shares of common stock outstanding, and 1.5 million 8% percent semi-annual bonds outstanding, par value $100 each. The common stock currently sells for $25 per share, and has a beta of 1.25, and the bonds have 10 years to maturity and sell for 93% of par. Cost of debt is 9.5%. The market risk premium is 10%, the return on risk free rate is 4.5%, and tax rate is 30%.
a) What is the firm’s market value of debt and equity?
b) Caterpillar is evaluating a new investment project that has the same risk as the overall firm, what is the rate that the firm should use to discount the project’s cash flows?
Explanation / Answer
a) Market value of debt = 1.5 * 1000000 * 100 * 0.93 = $ 139500000 [1 Million = 1000000]
Market value of equity = 8 * 1000000 * 25 = $ 200000000 [ 1 Million = 1000000]
Conclusion:- Market value of debt = $ 139500000 and Market value of equity = $ 200000000.
b) Cost of debt = 9.5 % (Directly given in the question. It is assumed to be after tax only)
Cost of equity = Risk free rate + Beta * market risk premium
= 4.5 + 1.25 * 10
= 17 %
Calculation of weighed average cost of capital on the basis of market value weights:-
Conclusion: The firm should use discount rate of 13.925 % to discount the project's cash flows.
Weight Cost (%) Weight * Cost Debt = 139500000 / 139500000 + 200000000 0.41 9.5 3.895 Equity = 200000000 / 139500000 + 200000000 0.59 17 10.03 Total 1 13.925 %Related Questions
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