- Develop sound analytical frameworks to grasp the process of decision making with respect to making investment in fixed assets and the methods used to evaluate new projects.
- Understand what free cash flow is and how to measure it.
- Understand a company’s capital structure and dividend policy.
The following information is available for Solley Corporation:
Debt: 5,000 bonds outstanding that are selling for 96 percent of par. Bonds with similar characteristics are yielding 8.5 percent, pretax. The bond par value is €1,000.
Common stock: 43,800 shares outstanding, selling for €51 per share; the beta is 1.54.
Preferred stock: 10,000 shares of 7 percent preferred stock outstanding with a stated value of €100 per share, currently selling for €83 per share.
Market: 7.5 percent market risk premium and 3.6 percent risk-free rate.
Assume the company’s tax rate is 21 percent.
Instructions:
- Calculate the firm’s market value capital structure.
- Calculate the firm’s costs of common equity, preferred stock and debt.
- Calculate the weighted average cost of capital (WACC).
- What discount rate should the firm apply to a new project’s cash flows if the project has the same risk as the company’s typical project? Explain.
- What happens if we use the WACC as the discount rate for all projects? Explain.
- Which is more relevant, the pretax or the after-tax cost of debt? Explain.
- Which are more relevant, the book or market value weights? Explain.
