Copper Strike Mining Company (CSMC) needs to raise $55,000,000 for the development of a new mining site and will do so by issuing either new bonds or new preferred shares. If CSMC issues preferred shares or bonds to finance this project, it is estimated that the beta will increase to 1.8. The following outlines the information on these two options:

1. Bonds: Bonds with a face value of $55,000,000. The bonds will pay interest at 8%, which is payable quarterly, and mature in 15 years. Current yield to maturity (YTM) on similar bonds is 8%, compounded quarterly.

2. Preferred shares: 440,000 non-voting preferred shares at $125 per share. The preferred shares will be non-cumulative with an annual dividend of $9.00 per share.

The company has the following issued capital:

1. Bonds issued to RD Mining Inc., a private investor. The bonds have a face value of $59,800,000 and a coupon rate of 7%, payable semi-annually. The bonds mature in 10 years. Similar bonds which are actively traded have a current YTM of 7.5%.

2. There are 200,000 non-voting preferred shares outstanding that pay an annual dividend of $2.40 per share. The dividends are cumulative. Currently, preferred shares with similar risk require a return of 9%. The company tries to pay the dividends on these shares every year and has done so for the last four years.

3. There are 1,000,000 common shares outstanding. Recently, the company had a valuation completed which calculated the current market value to be $75 per common share.

4. Management had recent discussions with an investment banker and determined that flotation costs (including legal fees) for private financing will be 6% before tax on new issues of common and preferred shares, and 3% after tax on new issues of debt.

5. CSMC’s corporate income-tax rate is 25%.

6. Based on market data, you have determined that the current risk-free rate is 4% and the expected market price of risk is expected to be 7%. You have estimated that the company’s beta is 1.7.

CSMC has done no analysis of its optimal capital structure and understands that either of the two options would change its capital structure. The company is interested in knowing how the two options compare to the option of using the company’s retained earnings.

Required:

a) Calculate the company’s current weighted average cost of capital (WACC) and the WACC under both options. 

b) Describe the advantages and disadvantages associated with each of these proposals, including the implications on cash flows and net earnings of either option, and make a recommendation as to which proposal should be accepted. (Note: Calculations of cash flows and net earnings are not required.) 

Answer rating: 100% (QA)

a To calculate the WACC the general formula to use is WACC weight Equity Cost of equity weight Debt Aftertax Cost of Debt weight Preferred shares Cost of preferred shares Cost of Equity is derived fro... View the full answer