Question

Assume the market value of Exxon Mobil’s equity, preferred stock, and debt are $10 million, $6 million, and $14 million, respectively. The preferred stock outstanding pays a 9% annual dividend and has a par value of $100. The common stock currently has a beta of 1.15, the preferred stock currently sells for $80 per share, and the 10% semiannual bonds have 17 years to maturity and sell for 91% of par. The market risk premium is 11.5%, T-bills are yielding 7.5%, and the firm's tax rate is 32%. What discount rate should the firm apply to a new project's cash flows if the project has the same risk as the firm's typical project?

Answer 1

Annual preferred dividend = 0.09 * 100 = 9

Cost of preferred stock = (Annual dividend / price) * 100

Cost of preferred stock = (9 / 80) * 100

Cost of preferred stock = 11.25%

Cost of equity = Risk free rate + beta ( market risk premium)

Cost of equity = 0.075 + 1.15 (0.115)

Cost of equity = 0.20725 or 20.725%

Coupon = (0.1 * 1000) / 2 = 50

Price = 0.91 * 1000 = 910

Number of periods = 17 * 2 = 34

Yield to maturity = 11.1951%

Keys to use in a financial calculator: 2nd I/Y 2, FV 1000, N 34, PMT 50, PV -910, CPT I/Y

Total market value of capital structure = 10 + 6 + 14 = 30

Discount rate = (10 / 30)*0.20725 + (6 / 30)*0.1125 + (14 / 30)*0.111951*(1 - 0.32)

Discount rate = 0.06908 + 0.0225 + 0.03553

Discount rate = 0.1271 or 12.71%