Titan Mining Corporation is financed with half equity and half debt. Their finan

Question

Titan Mining Corporation is financed with half equity and half debt. Their financial structure includes 9.3 million shares of common stock trading at $34 per share with a of 1.20. Their debt is composed of 6.8 percent coupon bonds maturing in 20 years and selling for 104 percent of par. They pay a tax rate of 35 percent. Return on the market portfolio is 10.5 percent and return on the risk-free investment is 3.5 percent. Titan Mining is evaluating a new investment project with half the business risk of their typical projects - specifically, the project under consideration has a 0 of 1/2 the magnitude of the 0 of their typical projects. In addition, suppose management has re-appraised the overall riskiness of their business going forward - they have concluded that they are going to transition to a new capital structure composed of 80 percent debt, 20 percent equity. What weighted average cost of capital, given this lower business risk but higher financial risk, should the firm use to discount the project's cash flows?

Explanation / Answer

1) Find the asset beta or unlevered equity beta of Titan. Unlevered beta = Levered beta/[1+(1-t)*D/E] The current D/E ratio = 1/1 [Debt equity ratio is taken as 1:1 as the question says 'financed with half equity and half debt'. The number of bonds is not give to ascertain market value ratios.] Unlevered beta = 1.2/(1+0.65) = 0.7272 Asset beta (signifying business risk for new venture) 0.7272/2 = 0.36 2) Levered beta for new venture = 0.36*[1+(0.65*0.8/0.2)]= 0.94 3) Cost of equity for new venture as per CAPM = 3.5+0.94*(10.5-3.5) = 10.08% YTM of bonds using a YTM calculator = 6.44 After tax cost of debt = 6.44*0.65 = 4.19% 4) WACC for new venture = 10.08*0.20+4.19*0.80 = 5.37% ANSWER: OPTION [C] NONE OF THESE VALUES ARE CORRECT.

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