In order to accurately assess the capital structure of a firm, it is necessary to convert its balance sheet figures to a market value basis. K Corporation’s balance sheet as of today, January 1, 2015 is as follows:
The long-term bonds have a 4.2 percent nominal annual coupon rate, payable semi-annually, and a par value of $1,000. They mature on January 1, 2028. The yield to maturity is 10 percent, so the bonds now sell below par. The Corporation has no Notes payable. Its preferred stock will mature in 2016.
K Corporation has a Beta of 1.35 and an expected dividend growth rate of 5.00% per year. Currently, the short-term Treasury bill rate is 3.00%, and the twenty-year Treasury bond rate is 3.50%. The annual return on the stock market during the past 3 years was 15.50%. Investors expect the annual future stock market return to be 11.50%.
The current stock price is $5.45 per share. The company decided a couple of years ago that its target capital structure should have 40% debt, with the balance being common equity; the given Beta reflects that capital structure. The effective tax rate is expected to be 40% beginning in 2015.
a. What is the current market value of the firm’s debt (to the nearest dollar)?
b. What is the current market value of K’s equity (to the nearest dollar)? c. Using the SQL, what is K Corp’s required equity return (to two decimal places)? d. Calculate the Corporation’s WACC (to two decimal places). e. If a corporate-wide project has a projected rate of return (or IRR) of 11.5%, should K Corporation undertake the project? Explain your rationale (in 1 or 2 sentences).
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