Question

The Big Easy Inc. target capital structure calls for 30% debt, 10% preferred stock, and 60% common equity. It has outstanding 25-year noncallable bonds with a face value of $1,000, a 9% semi-annual coupon, and a market price of $1,187.66. The tax rate is 40%. The company’s preferred stock currently trades at $65 and pays a $5 annual dividend per share. The company’s common stock, on the other hand, currently trades at $35 a share and just paid $4.56 annual dividend per share. The dividend is expected to grow at a constant rate of 3% a year. In addition, the risk-free rate is 6%, the average return on the market is 10%, and the firm’s beta is 1.5. Given the following information, answer the following questions:

1. What is the flotation cost adjustment?
2. What is the cost of external equity?
3. Calculate the WACC if the common equity comes from retained earnings.
4. Calculate the WACC if the common equity comes from new stocks.
5. If the company is considering the following capital budgeting projects:

          Project    Size     Rate of Return

     A           $1M              13%

B           $2M              12.5%

C           $2M              12%

D           $2M              11.9%

E           $1M              11%

F           $1M              10.56%

G           $1M             10%

Which set of projects should be accepted?

Answer 1

A-floation cost adjustment is called when flotation cost related to issue of any of the financial securities is adjusted in the issue price and cost of component is calculated considering the flotation expense
semi annual before tax cost of bond = Using rate function in MS excel	rate(nper,pmt,pv,fv,type) nper =25*2 =50 pmt =1000*9%*1/2 =45 pv = 1187.66 fv =1000 type =0	RATE(50,-45,1187.66,-1000,0)	3.67%
annual after tax cost of debt	(2*semiannual rate)*(1-tax rate)	(2*3.67)*(1-.40)	4.40
cost of preferred cost	preferred dividend/market price	5/65	7.69%
cost of common stock-retained earnings	risk free rate+(market return-risk free rate)*beta	6+(10-6)*1.5	12
B-
cost of common stock-new stock	(expected dividend/net proceeds)+growth rate	(4.7/35)+3%	16.43%
expected dividend	4.56*1.03		4.6968
growth rate			3%
market price			35
C-
WACC-retained earnings
source	weight	component cost of capital	weight*component cost
debt	0.3	4.40%	0.0132
preferred	0.1	7.69%	0.00769
equity	0.6	12%	0.072
total
WACC =sum of weight*component cost			9.29%
D-
WACC-new stock
source	weight	component cost of capital	weight*component cost
debt	0.3	4.40%	0.0132
preferred	0.1	7.69%	0.00769
equity	0.6	16%	0.09858
total
WACC =sum of weight*component cost			11.95%
E-
Project	rate of return	WACC -new stock	Accept if rate of return > WACC new stock Reject if rate of return<WACC -new stock
A	13%	11.95%	Accept
B	12.50%	11.95%	Accept
C	12%	11.95%	Accept
D	11.90%	11.95%	Reject
E	11%	11.95%	Reject
F	10.56%	11.95%	Reject
G	10%	11.95%	Reject
Set of project for Investment	A,B & C