Question

            You develop the following information. Your firm has a target capital structure of 70% common equity, 5% preferred stock and 25% debt. The firm’s tax rate is 25%.

The firm can issue up to $200,000 worth of debt at a before-tax cost of 9%. Then it will cost the firm 11% before-tax on debt up to $400,000. After that point, the before-tax cost of debt will be 13%.

The firm’s preferred stock carries an annual dividend of $2 per share. The issue price of the preferred would be $25 with 1.5% of the issue price charged as flotation costs.

The firm expects to have $950,000 in earnings and have a dividend payout ratio of 65%. The firm bases its cost of retained earnings on the CAPM approach. For this purpose, you determine the growth rate of the market will be 5% and the market dividend yield is 2%. The risk-free rate is 3%. The firm’s beta is 1.05.

The firm can issue new common stock with a $0.50 dividend, price of $20 per share, flotation costs of 1.75% of issue price and growth rate expected of 6%. This holds for up to $630,000 in equity after which it will cost 10% for new common stock.

1-Determine the marginal cost of capital schedule.

2-Determine which projects you would accept and what the optimal capital budget would be by combining the investment opportunity schedule (information below) and marginal cost of capital schedule.

Project       Initial Cost      IRR

A               $375,000         8.5%

B               $300,000         11%

C               $175,000         10%

D               $100,000         7.5%

E                $200,000         6%

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Answer 1

Formula sheet

A	B	C	D	E	F	G	H	I
2		1)
3		Input Data:
4		Current Price of Common Stock	20
5		Current Dividend	0.5
6		Payout Ratio	0.65
7		Growth	0.06
8		Flotation cost	0.0175
9		Net Income	950000
10		Before Tax Cost upto $200,000 borrowings	0.09
11		Before Tax Cost upto $400,000 borrowings	0.11
12		Before Tax Cost above $400,000 borrowings	0.13
13
14		Preferred Stock
15		Annual Dividend per share	2
16		Floatation cost	0.015	of issue price
17		Current Price	25
18
19		Tax rate	0.25
20
21		Target Capital Structure
22		Common Equity	0.7
23		Preferred Stock	0.05
24		Debt	0.25
25
26		The marginal cost of capital (MCC) is the cost of raising a dollar of new capital.
27
28		Retained Earnings	=Net Income*(1-Payout Ratio)
29			=D9*(1-D6)
30
31		Breakpoin is the capital budget size at which MCC changes (breakpoints).
32		Firms marginal cost of capital breakpoint is given by following equation,
33		Breakpoint (BP) = Limit/ Proportion of Total
34
35		Breakpoint for Retained Earnings	=Retained Earnings / Proportion of Equity
36			=D29/D22	=D29/D22
37
38		Thus if Capital budget requirement is below $475,000, then retained earnings will be sufficient to maintain the capital structure.
39		However if the capital requirement is above $475,000 then new equity to be raised.
40		Cost of new Equity after $630,000 new Equity	0.1
41		Limit on new Equity	630000
42		Breakpoint for New Equity	=Limit on Equity / Proportion of Equity
43			=(D41+D29)/D22	=D29/D22
44
45		Breakeven Points of debt can be calculated as follows:
46		Debt Limit	200000	400000
47		Proportion of Debt	=D24	=D24
48		Breakeven Points of debt	=D46/D47	=E46/E47
49
50
51		Calculation of cost of retained earnings:
52		Cost of retained earnings can be calculated using CAPM as follows:
53
54		As Per CAPM, Expected rate of return can be calculated as
55		r(E) = rf + ?*(rm-rf)
56		Using the Following data
57		Beta (?)	1.05
58		Risk free rate ( rf )	0.03
59		Market Return (rm) = Market Div. Yield + Market Growth rate	=2%+5%
60
61		Expected rate of return can be calculated as follows:
62		Expected rate of return	= rf + ?*(rm-rf)
63			=D58+D57*(D59-D58)	=D58+D57*(D59-D58)
64
65		Hence Cost of Retained Earnings is	=D63
66
67
68		Calculation of cost of new equity:
69		Using dividend growth model, cost of new equity can be calculated using following formula:
70
71
72
73		Where Div0 is current period dividend, P is current price of the share, F is floatation cost and g is the growth rate of dividend.
74
75		Using the following data:
76		Current Dividend (Div0)	=D5
77		Price (P0)	=D4
78		Growth rate (g)	=D7
79		Floatation cost (F)	=D8
80		From Dividend growth model,
81		Cost of equity, r(E)	= [(Div0)*(1+g)/{P*(1-F)}]+g
82			=(D76*(1+D78))/(D77*(1-D79))+D78	=(D76*(1+D78))/(D77*(1-D79))+D78
83
84		Hence Cost of New equity upto capital budget of $1,375,000 is	=D82
85
86
87		Calculation of Cost of preferred stock:
88		Annual Dividend of preferred stock	=D15
89		Current Price	=D17
90		Floatation cost (F)	=D16
91		Cost of preferred stock	=Dividend/Current Price*(1-F)
92			=D88/(D89*(1-D90))	=D88/(D89*(1-D90))
93
94		Hence cost of Preferred Stock is	=D92
95
96		Formula for MCC or WACC is given as:
97		WACC = r(E) × w(E) + r(P) × w(P)+r(D) × (1 – t) × w(D)
98		Where, r(E), r(P) and r(D) are cost of equity, preferred stock and cost of debt,
99		w(E), w(P) and W(D) are weight of equity, preferred stock and debt and t is the tax rate
100
101		Target Capital Structure
102		Common Equity	=D22
103		Preferred Stock	=D23
104		Debt	=D24
105
106		Tax Rate	=D19
107		Weight of common equity, Long-term debt and preferred equity can be calculated as follows:
108
109		MCC Breakpoints are	=D36	=D48	=D43	=E48
110
111		MCC for different level of capital budget can be Calculated as follows:
112		Capital Budget Required	<$475,000	$475,000 - $800,000	800,000-1,375,000	1375000-1600000	>1600000
113		Cost of Equity	=D65	=$D$84	=$D$84	=$D$40	=$D$40
114		Cost of Preferred Stock	=$D$94	=$D$94	=$D$94	=$D$94	=$D$94
115		Before Tax Cost of Debt	=$D$10	=$D$10	=$D$11	=$D$11	=D12
116		MCC (WACC)	=$D$102*D113+$D$103*D114+$D$104*D115*(1-$D$106)	=$D$102*E113+$D$103*E114+$D$104*E115*(1-$D$106)	=$D$102*F113+$D$103*F114+$D$104*F115*(1-$D$106)	=$D$102*G113+$D$103*G114+$D$104*G115*(1-$D$106)	=$D$102*H113+$D$103*H114+$D$104*H115*(1-$D$106)
117
118		Hence
119		Capital Budget Required	<$475,000	$475,000 - $800,000	800,000-1,375,000	1375000-1600000	>1600000
120		MCC	=D116	=E116	=F116	=G116	=H116
121
122		2)
123		As per IRR rule, project with IRR higher than WACC should be accepted.
124		Project	Initial Cost	IRR	WACC	Accept / Reject
125		A	375000	0.085	=$D$120	Accept
126		B	300000	0.11	=$D$120	Accept
127		C	175000	0.1	=$D$120	Accept
128		D	100000	0.075	=$D$120	Accept
129		E	200000	0.06	=$D$120	Reject
130