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Hankins Corporation has 79 million shares of common stock outstanding. 295,000 shares of 4.2 percent preferred stock outstand

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Answer #1

Requirement (a) – Firm’s Market Value Capital Structure

Capital Components

Calculation

Market Value Capital Structure Weights

Debt

[$381,600,000 / 868,710,000]

0.4393

Preferred Stock

[$28,910,000 / 868,710,000]

0.0333

Equity

[$458,200,000 / 868,710,000]

0.5274

Calculations

Market Value of Debt = $381,600,000 [180,000 Bonds x ($2,000 x 106%)]

Market Value of Preferred Stock = $28,910,000 [295,000 shares x $98 per share]

Market Value of Equity = $458,200,000 [7,900,000 shares x $58 per share]

Total Market Value = $868,710,000

Requirement (b) – Discount Rate to be used by the firm to discount the project's cash flows

After-tax Cost of Debt

The After-Tax Cost of Debt is the After-Tax Yield to maturity of (YTM) of the Bond and is calculated using financial calculator as follows (Normally, the YTM is calculated either using EXCEL Functions or by using Financial Calculator)

Variables

Financial Calculator Keys

Figure

Face Value [$2,000]

FV

2,000

Coupon Amount [$2,000 x 5.70%]

PMT

114

Yield to Maturity [YTM]

1/Y

?

Time to Maturity [17 Years x 2]

N

34

Bond Price [-$2,000 x 106%]

PV

-2,120

We need to set the above figures into the financial calculator to find out the Yield to Maturity of the Bond. After entering the above keys in the financial calculator, we get the yield to maturity (YTM) on the bond = 10.63%

The After-tax Cost of Debt is the after-tax Yield to maturity of the Bond

After Tax Cost of Debt = Yield to maturity x (1 – Tax Rate)

= 10.63% x (1 – 0.23)

= 10.63% x 0.77

= 8.19%

Cost of Preferred Stock

Cost of Preferred Stock = [Annual Preferred Dividend / Selling Price] x 100

= [($100 x 4.20%) / $98] x 100

= [$4.20 / $98] x 100

= 4.29%

Cost of Equity

As per CAPM Approach, the Cost of Equity = Risk-free Rate + [Beta x Market Risk Premium]

= Rf + [B x Risk Premium]

= 3.40% + [1.10 x 6.70%]

= 3.40% + 7.37%

= 10.77%

Discount Rate to be used by the firm to discount the project's cash flows

Therefore, Discount Rate = [After Tax Cost of Debt x Weight of Debt] + [Cost of Preferred stock x Weight of preferred stock] + [Cost of equity x Weight of Equity

= [8.19% x 0.4393] + [4.29% x 0.0333] + [10.77% x 0.5274]

= 3.60% + 0.14% + 5.68%

= 9.42%

“Hence, the Discount Rate to be used by the firm to discount the project's cash flows will be 9.42%”

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