Exercise – Capital Structure

Titan Mining Corporation has 9 million shares of common stock outstanding,

250,000 shares of 6 percent preferred stock outstanding, and 105,000 7.5
percent semiannual bonds outstanding. The common stock currently sells for
$34 per share and has a beta of 1.25, the preferred stock currently sells for
$91 per share, and the bonds have 15 years to maturity and sell for 93
percent of par. The market risk premium is 8.5 percent, T-bills are yielding 5
percent, and Titan Mining’s tax rate is 35 percent.

You are required to:

(a) Determine the firm’s market value capital structure.

Answer:
MVD = 105,000($1,000)(0.93) = $97,650,000
MVE = 9,000,000($34) = $306,000,000
MVP = 250,000($91) = $22,750,000

And the total market value of the firm is:

V = $97,650,000 + 306,000,000 + 22,750,000 = $426,400,000

So, the market value weights of the company’s financing is:

D/V = $97,650,000/$426,400,000 = .2290

P/V = $22,750,000/$426,400,000 = .0534
E/V = $306,000,000/$426,400,000 = .7176

(b) If Titan Mining is evaluating a new investment project that has the same risk
as the firm’s typical project, determine the rate should the firm use to discount
the project’s cash flows.

Answer:
For projects equally as risky as the firm itself, the WACC should be used as the
discount rate.

First we can find the cost of equity using the CAPM. The cost of equity is:

RE = .05 + 1.25(.085) = .1563 or 15.63%

The cost of debt is the YTM of the bonds, so:

P0 = $930 = $37.5(PVIFAR%,30) + $1,000(PVIFR%,30)

R = 4.163%
YTM = 4.163% × 2 = 8.33%

And the aftertax cost of debt is:

RD = (1 – .35)(.0833) = .0541 or 5.41%

The cost of preferred stock is:

RP = $6/$91 = .0659 or 6.59%

Now we can calculate the WACC as:

WACC = .0541(.2290) + .1563(.7176) + .0659(.0534) = .1280 or 12.80%

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