Question

XYZ Company has 40% debt 60% equity as optimal capital structure. The nominal interest rate for the company is 12% up to $5 million debt, above which interest rate rises to 14%. Expected net income for the year is $17,5 million, dividend payout ratio is 45%, last dividend distributed was $4,5/share, P0 = $37, g=5%, flotation costs 10% and corporate tax rate is 40%.

a. Find the break points

b. Calculate component costs (cost of each financing source)

c. Calculate WACCs.

d. Two projects are available:

1st. Project requires 15 million initial investments, IRR=18%

2nd. Project requires 10 million initial investments, IRR=12%

Please find the optimal capital budget. (Project(s) to be invested in)   

Answer 1

Answer 1 & 2:

Break-Even Point is the point where gains = losses, until the change in the capital structure takes place. On the other hand component costs are individuals cost assigned to a particular field.

To find out the break-even point in this case, first we need to calculate the following component costs:

1. Retention Ratio = 100% – Dividend Payout Ratio

                          = 100% – 45%                            

                          = 55%

2. Retained Earnings = Expected Income x Retention Ratio

                               = $17.5 Mn x 55%

                               = $9.625 Mn

3. Total Capital = Retained Earnings ÷ % of Equity

                     = $9.625 Mn ÷ 60%

                     = $16.04167 Mn

4. Cost of Retained Earnings = Dividend distributed x (1 + Growth Rate ) ÷ (Current Share Price + Growth Rate)

                                           = 4.5 x (1.05) ÷ (37 + 0.05)

                                           = 0.127530364 or 12.75%

5. Cost of new Equity = 4.5 x (1.05) ÷ (37 x (1 – 0.05))

                               = 0.134423897 or 13.44%

Here-in-case;

∴ Break-even Point 1 = Total Capital = $16.04167 Mn

   Break-even Point 2 = Debt Borrow Limit ÷ % of Debt

                                  = $5 Mn ÷ 40 %

                                  = $12.5 Mn

Answer 3:

∴ WACC at Break-even Point 1 = [40% x 12% x (1 – 40%)] + [60% x 12.75%]

                                                    = 0.0288 + 0.0765

                                                    = 0.1053 or 10.53%

WACC at Break-even Point 2 = [40% x 14% x (1 – 40%)] + [(9.625 ÷ 12.50) x 12.75%] +

[(12.50 x 60% – 9.625) ÷ 12.5 x 13.44%]

                                                = 0.0336 + 0.098175 + (– 0.022848)

                                                = 0.108927 or 10.89%

Answer 4:

Both the Projects (1^st & 2^nd) of the Company will be profitable since their IRR (18% & 12%) respectively, is above the range of the Company’s Cost of Capital, i.e, 10.53% – 10.89%.

However, the Company should choose Project A as an optimal capital budget, since it has a greater IRR than Project B. (18% > 12%)