Question

Forrest Corporation has 500,000 shares of common stock, 10,000 shares of preferred stock, and 5,000 bonds with 8 percent (coupon) outstanding. The common stock currently sells for $25 per share and has a beta of 0.95. Preferred stocks pay a dividend of $8 per share and currently sell for $98 with a floatation cost of $2 per share. The bonds have par value of $1,000, 20 years to maturity, currently sell for 102.5 percent of par, and the coupons are paid semiannually. The bond’s floatation cost is 1% of the current market price. The expected return on market portfolio is 9 percent, T-bills are yielding 2 percent, and the tax rate is 35 percent. What is the firm’s market value capital structure? If Forrest 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?

Answer 1

Market Value of debt = $1025 x 5000 bonds = $5,125,000

Market Value of Common Stocks = $25 x 500,000 shares = $12,500,000

Market Value of Preferred Srocks = $98 x 10,000 shares = $980,000

Total Capital Emplyed = $5,125,000 + $12,500,000 + $980,000 = $18,605,000

Debt % in total capital = $5,125,000 $18,605,000 = 27.55%

Common equity % in total capital = $12,500,000 $18,605,000 = 67.18%

Preferred Stock % in total capital = $980,000 $18,605,000 = 5.27%

If Forrest is evaluating a new investment project that has the same risk as the firm’s typical project, then the firm should use Weighted Average Cost of Capital (WACC) to discount the project’s cash flows.