“Raymond Mining Corporation’s Market Value Capital Structure and Discount Rate for Investment Evaluation”

QUESTION

Raymond Mining Corporation has 8.5 million shares of common stock outstanding. 250,000 shares of 5% preferred stock outstanding, and 135,000 7.5% semiannual bonds outstanding, par value $1000 each. 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 114% of par. The market risk premium is 7.5%, T-bills are yielding 4%, and the company’s tax rate is 35%.

1. What is the firm’s market value capital structure?
2. If Raymond Mining 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

The market value capital structure of a company represents the proportion of different types of securities it has outstanding in relation to their market values. To calculate Raymond Mining Corporation’s market value capital structure, we need to determine the market values of its common stock, preferred stock, and bonds.

1. Common Stock:
Raymond Mining has 8.5 million shares of common stock outstanding, and each share currently sells for $34. Therefore, the market value of the common stock is:
Market Value of Common Stock = Number of Common Shares × Price per Share
Market Value of Common Stock = 8,500,000 shares × $34/share = $289,000,000

2. Preferred Stock:
The company has 250,000 shares of 5% preferred stock outstanding, and each share currently sells for $91. The market value of the preferred stock is:
Market Value of Preferred Stock = Number of Preferred Shares × Price per Share
Market Value of Preferred Stock = 250,000 shares × $91/share = $22,750,000

3. Bonds:
Raymond Mining has 135,000 7.5% semiannual bonds outstanding with a par value of $1,000 each. The bonds sell for 114% of par, so their market value is:
Market Value of Bonds = Number of Bonds × Price per Bond
Market Value of Bonds = 135,000 bonds × 1.14 (114% of par) × $1,000 = $153,900,000

Now, we can calculate the total market value of the company’s capital structure:

Total Market Value Capital Structure = Market Value of Common Stock + Market Value of Preferred Stock + Market Value of Bonds
Total Market Value Capital Structure = $289,000,000 + $22,750,000 + $153,900,000 = $465,650,000

So, the firm’s market value capital structure consists of approximately $465.65 million in common stock, preferred stock, and bonds.

Now, let’s determine the discount rate that Raymond Mining should use to evaluate a new investment project with the same risk as the firm’s typical projects. The appropriate discount rate for the project is the weighted average cost of capital (WACC). WACC takes into account the cost of each component of the capital structure (common equity, preferred equity, and debt) and their respective weights.

WACC Formula:
WACC = (E/V) * Re + (P/V) * Rp + (D/V) * Rd * (1 – Tax Rate)

Where:
– E = Market Value of Common Equity
– V = Total Market Value of Capital Structure
– Re = Cost of Common Equity (required rate of return)
– P = Market Value of Preferred Equity
– Rp = Cost of Preferred Equity (required rate of return)
– D = Market Value of Debt
– Rd = Cost of Debt (yield on bonds)
– Tax Rate = Corporate Tax Rate

In this case, we have already calculated the market values of common stock, preferred stock, and bonds, which are E, P, and D, respectively. We also have the tax rate.

Now, we need to determine the required rates of return for each component:

1. Cost of Common Equity (Re):
The cost of common equity can be calculated using the Capital Asset Pricing Model (CAPM):

Re = Rf + Beta * Market Risk Premium
Re = 4% (T-bill yield) + 1.25 (Beta) * 7.5% (Market Risk Premium)
Re = 4% + 9.375%
Re = 13.375%

2. Cost of Preferred Equity (Rp):
Since preferred stock is like a perpetuity, we can calculate its cost as the dividend rate:

Rp = Preferred Dividend Rate = 5%

3. Cost of Debt (Rd):
The cost of debt is the yield on the bonds. The bonds sell for 114% of par and have a 7.5% coupon rate, so:

Rd = (Coupon Payment / Bond Price) + (1 – Tax Rate)
Rd = (0.075 * $1,000) / ($1,140) + (1 – 0.35)
Rd ≈ 6.579% + 0.65%
Rd ≈ 7.229%

Now, we can calculate the weights of each component:

– Weight of Common Equity (E/V) = $289,000,000 / $465,650,000 ≈ 0.62
– Weight of Preferred Equity (P/V) = $22,750,000 / $465,650,000 ≈ 0.05
– Weight of Debt (D/V) = $153,900,000 / $465,650,000 ≈ 0.33

Now, we can calculate the WACC:

WACC = (0.62 * 13.375%) + (0.05 * 5%) + (0.33 * 7.229%)
WACC ≈ 8.29%

Therefore, the firm should use a discount rate of approximately 8.29% to evaluate the new investment project, assuming it has the same risk as the firm’s typical projects. This rate reflects the weighted average cost of capital, taking into account the cost of common equity, preferred equity, and debt in the company’s capital structure.