Question

As a consultant to Kmart, you have been asked to compute the appropriate discount rate to use in the evaluation of the purchase of a new warehouse facility. The target capital structure weights are equal across debt, preference shares, and ordinary shares. You have determined the market value of the firm’s current capital structure (which the firm considers to be its target mix of financing sources) as follows:

To finance the purchase, Kmart will sell 10-year bonds with a $1000 face value paying 6% per year at the market price of $1000. Preference shares paying a $2.50 dividend can be sold for $25. Ordinary shares for Kmart are currently selling for $50 each. The firm paid a $4 dividend last year and expects dividends to continue growing at a rate of 4% per year into the indefinite future. The firm’s marginal tax rate is 30%. What discount rate should you use to evaluate the warehouse project? (25)

Answer 1

Before tax Cost of Debt =6% (Since it is sold at par value, cost of debt=Coupon rate)

After tax cost of debt =6%*(1-Tax Rate)=6%*(1-0.3)=4.2%

Cost of Preference Shares=2.5/25=10%

Cost of Ordinery Shares:

D0=Current dividend=$4

g=growth rate=4%=0.04

D1=Next year's dividend =D0*(1+g)=4*1.04=$4.16

P0=Market Price =$50

R=Cost of ordinary shares

Cost of Ordinary Shares= R=(D1/P0)+g=(4.16/50)+0.04=0.1232=12.32%

Target Capital Structure Weights:

Debt=1/3

Preference share=1/3

Ordinary Share=1/3

Discount Rate =Weighted Average Cost of Capital (WACC)

WACC=(1/3)*4.2%+(1/3)*10%+(1/3)*12.32%=8.84%

Discount Rate to be used

8.84%

answered by: anonymous