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compute the appropriate discount rate

As a consultant to GBH Skiwear, you have been asked to compute the appropriate discount rate to use to evaluate the purchase of a new warehouse facility. You have determined the market value of the firm's capital structure as follows:

Source of Capital Market Value

Bonds $500,000
Preferred stock $100,000
Common stock $400,000

To finance the purchase, GBH will sell 20-year bonds, paying 8 percent per year, at the market price of $950. Flotation costs for issuing the bonds are 6 percent of the market price. Preferred stock paying a $2.50 dividend can be sold for $35; the cost of issuing these shares is $5 per share. Common stock for GBH is currently selling for $50 per share. The firm paid a $2 dividend last year and expects dividends to continue growing at a rate of 8 percent per year. Flotation costs for issuing new common stock will be 10 percent of the market price. The firm's marginal tax rate is 34 percent. What discount rate should you use to evaluate the warehouse project? What discount rate should you use to evaluate the equipment purchase?

Solution Preview

This is actually a WACC problem:
<br>The bonds' yield to maturity is:
<br>N=20, Payment=1000*8%=80, FV=1000, PV= -950, Compute I/Y= 8.53%
<br>Then cost of bonds is Kb=IY*(1-t)/(1-f)=8.53*(1-.34)/(1-.06)=6.0%
<br>The ...

Solution Summary

This job computes the appropriate discount rates.

$2.19