Question

QUESTIONS 1 and 2 are based on the information below:

FLF Corporation is preparing to evaluate capital expenditure proposals for the coming year. Because the firm employs discounted cash flow methods, the cost of capital for the firm must be estimated. The following information is provided for your analyses—

1. The market price of common stock is $60/ share

2. The dividend next year is expected to be $3/share

3. The company has paid 10% dividends in the past; the company projected to keep that rate of dividend payments to keep their investors happy.

4. New bonds can be issued at face value with a 10% coupon rate in order to attract additional investors in bonds and not in stocks.

5. The total liabilities as of this date is $400M and total equity is $600M. The company considered this their optimal capital structure.

6. As of the latest investor relations press meeting, the CEO announced that the expected revenue will grow as projected and the intend to retain $3M of the earning for expansion plans.

7. The firm’s marginal tax rate is 40%.

Without prejudice, assume that the after-tax cost of debt financing is 10% , the cost of retained earnings is 14%, and the cost of new common stock is 16%.

Question 1: If the capital expansion needs to be $7M for the coming year, what is the after-tax weighted-average cost of capital?

Question 2: What is the marginal cost of capital for any projected capital expansion in excess of $7M?

Answer 1

Answer 1

To maintain the debt and equity proportion of of 40% and 60%, the financing of 7million will allotted in such a way that debt is 40% of 7 million and rest 60% is from equity

3million will be used from retained eanings (Point 6)

1.2 million of new stock (4.2million -3million)

2.8 million of debt

Total capital = 7 million Retained earnings weightage = 3/7 = 42.86%

Total capital = 7 million Equity new issue weightage = 1.2 / 7 = 17.14%

Total capital = 7 million debt new issue weightage = 2.8/7 = 40%

WACC = (cost of retained earnings * weight of retained earnings)+(Cost of NEW Equity * %age of NEW Equity) + (Cost of Debt After Tax * %age of Debt)

(14% * 42.86%) + (16% * 17.14%) + (10% *40%)

12.74%

Answer 2

For any further expansion over 7 million, the retained earning was already used when the capital to be raised was 7million.

Therefore any further requirement will be fulfilled only by new equity and new debt issue.

The optimal weighatges are given 40% debt 60% equity

cost of after tax debt given as 10% and cost of new equity 16%

WACC = (Cost of Debt After Tax * %age of Debt) +(Cost of NEW Equity * %age of Equity)

(10% * 40%) + (16% * 60%)

13.60%