Question

As a consultant to Gamma Skiwear, you have been asked to determine the appropriate discount rate to use in the evaluation of several projects. You have determined the firm’s current capital structure (which the firm considers to be its target mix of financing sources) as follows:
Source of capital Market value
Bonds ...........................................................$500,000
Preferred stock..............................................$100,000
Common stock..............................................$400,000

To finance acceptable projects, Gamma will sell 20-year bonds with a market rate of 9%. Preferred stock paying a $2.50 dividend can be sold for $24 per share. Common stock for Gamma 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 4% per year into the indefinite future. The firm’s tax rate is 35% percent.
The projects that Gamma is considering are as follows:


Gamma evaluates average projects at its weighted average cost of capital; evaluates low risk projects at a one percent discount; and, evaluates high risk projects at a three percent premium over the WACC.
Which projects should be accepted to create maximumvalue?


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  • CreatedJuly 26, 2013
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