Organic Produce Corporation has 6.3 million shares of common stock outstanding, 350,000 shares of 5.8 preferred stock outstanding, and 150,000 of 7.1 percent semiannual bonds outstanding, par value $1,000 each. The common stock currently sells for $74 per share and has a beta of 1.09, the preferred stock currently sells for $107 per share, and the bonds have 20 years to maturity and sell for 109 percent of par. The market risk premium is 6.8 percent, T-bills are yielding 4.3 percent, and the firm’s tax rate is 34 percent.

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

b. 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?

(a) The firm's market value capital structure is = 0.698

,0.245

, 0.056 (b))Therefore the rate the firm should use to discount the project's cash flows is 9.35%

Explanation:

From the example given, we solve for both (a) and (b)

Solution

Given:

(a) The Market Equity of Value = Number of Shares  Outstanding Shares*Current Selling Price = 6300000*74 = 466200000

Market  Debt Value of  = Number of Bonds*Current  Price selling = 150000*1000*109% = 163500000

Preferred Stock market value = Number of  shares outstanding *Current Selling Price = 350000*107 = 37450000

Then,

The Total Market Value = 466200000 + 163500000 + 37450000 = 667150000

The Weight of Equity in Capital Structure (E/V) = 466200000/ 667150000 = 0.698

The Weight of Debt in Capital Structure (D/V) = 163500000/667150000 = 0.245

The  Preferred Stock weight  in Capital Structure (P/V) = 37450000/667150000 = 0.056

(b)Cost of Equity =  Free Risk Rate + Beta * Risk Premium Market = 4.3 + 1.09*6.8 = 11.712%

The Cost of Stock Preferred = Current/Return Selling Price = (5.8%*100)/107*100 = 5.421%  

Thus,

Debit cost

Nper = 20*2 = 40

Where

PMT = 1000*.071*1/2 = 35.5  and FV = 1000

PV = 1000*109 = 1090

The Rate is unknown

Tax Cost of Debt After = Rate(Nper, PMT, PV, FV) = Rate(40,30.5,-1090,1000)*2*(1-.34) = 3.538%

Then,

WACC = After Tax Cost of Debt*Weight of Debt + Cost of Preferred Stock*Weight of Preferred Stock + Cost of Equity*Weight of Equity

WACC = 3.538*.245 + 5.421*.056 + 11.712*.698 = 9.345% or 9.35%

Therefore the rate the firm should use to  discount the project's cash flows is 9.35%