Long Ltd. is considering expanding its existing operations. To
evaluate the expansion proposal,
Long has provided the following information:
- Long's current capital structure consists of a $15 million face
value bond issue and 25 million common shares. Long believes that
its current debt-to-equity ratio of 0.235 (based on market values)
represents its optimal capital structure.
- The bonds have a remaining maturity of six years, offer a
coupon rate of 7% paid semi-annually and have a current market
value of $98 per $100 face value bond.
- The common shares are currently trading at a price of $2.50 per
share and their beta is 1.2.
- Flotation costs will be 4% after tax on both new issues of debt
and common equity.
- Long's tax rate is 34%, the market price of risk is6.5% and the
risk-free rate of return is 3.5%.
Determine the appropriate discount rate for Long to use in
evaluating the expansion proposal, assuming that the equity
component will be financed using retained earnings rather than by
issuing new common shares.