The new RDS project is somewhat riskier than a typical project for DEI, primarily because the plant is being located overseas. Management has told you to use an adjustment factor of 3 percent to account for this increased riskiness. Calculate the appropriate discount rate to use when evaluating DEI’s project.
Debt:
227,000 7.4 percent coupon bonds outstanding, 25 years to maturity, selling for 109 percent of par; the bonds have a $1,000 par value each and make semiannual payments.
Common stock:
769,000 shares outstanding, selling for $95.9 per share; the beta is 1.10.
Preferred stock:
36,900 shares of 6.40 percent preferred stock outstanding, selling for $93.9 per share.
Market:
8 percent expected market risk premium; 6 percent risk-free rate.
Can you do this question step-by-step please? I want to know how you got the answer?
N = 25 * 2; PV = 1000; FV = -1090; PMT = 74/2
It can't be that easy.. I think there's more to that...
To calculate the appropriate discount rate, we need to calculate the cost of each component of DEI's capital structure and then weight them according to their respective proportions in the capital structure.
1. Cost of Debt:
First, calculate the semi-annual coupon payment:
Coupon payment = 7.4% * $1,000 par value / 2 = $37
Next, calculate the yield to maturity (YTM) of the bonds:
YTM = (Coupon payment + ((Par value - Bond price) / Maturity period)) / ((Par value + Bond price) / 2)
YTM = ($37 + (($1,000 - ($1,000 * 109%)) / 25)) / (($1,000 + ($1,000 * 109%)) / 2)
Using the above equation, the YTM will be the discount rate for debt.
2. Cost of Common Stock:
The cost of common stock is calculated using the Capital Asset Pricing Model (CAPM).
Cost of equity = Risk-free rate + Beta * Market risk premium
Cost of equity = 6% + (1.10 * 8%)
3. Cost of Preferred Stock:
The cost of preferred stock is simply the dividend yield.
Cost of preferred stock = Preferred dividend / Stock price
Cost of preferred stock = 6.40% / $93.9
4. Proportions in the Capital Structure:
Calculate the proportion of each component in the capital structure:
Debt proportion = ($1,000 par value * 227,000 bonds) / (Total market value of debt + Total market value of equity + Total market value of preferred stock)
Common stock proportion = ($95.9 per share * 769,000 shares) / (Total market value of debt + Total market value of equity + Total market value of preferred stock)
Preferred stock proportion = ($93.9 per share * 36,900 shares) / (Total market value of debt + Total market value of equity + Total market value of preferred stock)
5. Weighted Average Cost of Capital (WACC):
Finally, calculate the weighted average cost of capital by multiplying the respective costs by the proportions and summing them up:
WACC = (Debt proportion * Cost of Debt) + (Common stock proportion * Cost of Common Stock) + (Preferred stock proportion * Cost of Preferred Stock)
Lastly, adjust the WACC for the increased riskiness by using the given adjustment factor of 3%:
Adjusted Discount Rate = WACC + 3%
By following these steps, you can calculate the appropriate discount rate to use when evaluating DEI's project.