Question

Max Laboratories Inc. has been operating for over thirty years producing medications and food for pets and farm animals. Due to new growth opportunities they are interested in your expert opinion on a series of issues described below. The firm has a target capital structure of 40 percent debt and 60 percent common equity, which the CFO considers to be the optimal capital structure and plans to maintain it in the future. Next year the firm forecasts Earnings per share (EPS) of $15. Max Labs has One million common shares outstanding. The firm has a line of credit at the local bank at the following interest rates: Can borrow up to $6,000,000 at an 8% interest rate; the rate goes to 10% for amounts above $6,000,000. The firm’s interest subsidy tax rate is 25 percent. The firm plans to retain 70% of the forecasted Net income; the remaining 30% of the estimated profits will be paid as dividends to common shareholders next year. Currently common shares sell for $110 and the expected earnings growth is 9%. The floatation costs to raise new common equity capital, equal 7% of the share price.

3. Calculate the Weighted average cost of capital at all the break points found on Question 2 above.
A) Before the firm has to raise new equity.
B) With the cost of new common equity but before the firm has to borrow at the higher interest rate.
C) With New cost of equity and at the most expensive cost of debt.

Answer 1

WACC:

A) Before the firm has to raise new equity.

Cost of equity:

ke=(Next dividend/Current market price per share)+Growth rate

ie. ((15*30%)/110)+9%=

13.09%

Cost of debt

8%*(1-25%)=

6.00%

WACC=(Wt.e*ke)+(Wt.d*kd)

ie.(60%*13.09%)+(40%*6%)=

10.25%

B) With the cost of new common equity but before the firm has to borrow at the higher interest rate.

Cost of new equity:

ke=(Next dividend/Net proceeds of new issue)+Growth rate

ie. ((15*30%)/(110*(1-7%)))+9%=

13.40%

Cost of debt

8%*(1-25%)=

6.00%

WACC=(Wt.e*ke)+(Wt.d*kd)

ie.(60%*13.40%)+(40%*6%)=

10.44%

C) With New cost of equity and at the most expensive cost of debt.

Cost of new equity:

ke=(Next dividend/Net proceeds of new issue)+Growth rate

ie. ((15*30%)/(110*(1-7%)))+9%=

13.40%

Cost of debt

10%*(1-25%)=

7.50%

WACC=(Wt.e*ke)+(Wt.d*kd)

ie.(60%*13.40%)+(40%*7.5%)=

11.04%