A firm is considering a new project which would be similar in terms of risk to its existing projects. The firm needs a discount rate for evaluation purposes. The firm has enough cash on hand to provide the necessary equity financing for the project. Also, the firm: - has 1,000,000 common shares outstanding

- current price $11.25 per share
- next year’s dividend expected to be $1 per share - firm estimates dividends will grow at 5% per year after that - flotation costs for new shares would be $0.10 per share - has 150,000 preferred shares outstanding

- current price is $9.50 per share
- dividend is $0.95 per share
- if new preferred are issued, they must be sold at 5% less than the current market price (to ensure they sell) and involve direct flotation costs of $0.25 per share - has a total of $10,000,000 (par value) in debt outstanding. The debt is in the form of bonds with 10 years left to maturity. They pay annual coupons at a coupon rate of 11.3%. Currently, the bonds sell at 106% of par value. Flotation costs for new bonds would equal 6% of par value.

The firm’s tax rate is 40%. What is the appropriate discount rate for the new project?

Solution:

Market value of common = 11.25(1000000) = $11,250,000
Market value of preferred = 9.50(150000) = $1,425,000
Market value of debt = 10000000(1.06) = $10,600,000
Total value of firm = $23,275,000

Cost of common:
(Note: floatation costs ignored for common equity because cash on hand is enough to finance the project.) [pic]

Cost of preferred:
[pic]

Cost of debt:
Net price = 106% - 6% = 100% of par value
Net price = par
Therefore, cost of debt = coupon rate
r = 11.3%

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