Question

A note to students on this problem.? yes, it is a bit involved so think about what information you will need to develop in order to answer the questions.?Hint:? ?You might want to take a look at Figure 12.4 on page 486.? I do not expect you to send me a graph, but you might find figure 12.4 helpful in figuring out what you need to know.

P-5.? The Acme Chip Manufacturing Company (potato not computer) has a target capital structure of 40% debt and 60% common equity.? They also have a 40% tax rate.? HINT:? you need this to calculate the "after-tax" cost of debt!

?They have three projects under consideration code named:? Manny, Moe, and Jack.? All are independent.

The IRRs for the three projects:

???? Manny????? 16%

???? Moe????????? 13%

???? Jack???????? 10%

All three projects have an initial investment of $1,000,000.

Acme can borrrow up to $2,000,000 from the bank at a quoted interest rate (the "before-tax" cost of debt) of 8%.? They also have a reported $3,000,000 in Retained Earnings available for new projects.?

Additional information:? The next common stock dividend they pay will be $4.00 per share.? They also expect a growth rate of 5% on common equity.? New common stock can be sold for $50.00 per share, with flotation costs of $10.00 per share.? Now if I were mean I would have you now calculate the "cost of issuing new common stock" - see page 368 in your text - as you have all the data you need.? OK - so I'm mean - BUT (hint time) if I were you at this point I'd go to page 368 and use equation 9.8 to figure out that cost of using new common stock!? But remember - it's always cheaper to use retained earnings than issuing new common stock.? Soooo as long as they have retained earnings to use (as they DO in part 1) you don't have to sell new common for part 1.? For part two on the other hand ...

Part 1:?

a.?? Which projects would you accept and why?? Yes, I need to see some "number crunching".

b.? What would be your capital budget?

Part 2:? Let's change one thing.? The federal government has decided to increase the regulations affecting the manufacturing of chips.? Complying with these new regulations will cost Acme $3 million, wiping out their retained earnings.?So now:

a. Which projects would you accept and why?? More number crunching please!

b.? What would be their capital budget now?

Answer 1

a. The projects will be chosen on the basis of their IRR.

Firstly Many, then Moe and finally Jack will be selected.

Now, cost of retained earnings = Div/Price of stock + growth rate

= (4*100/50) + 5 = 13%.

Cost of debt = 8%

Cost of new Equity = Dividend/(price - floatation costs) + growth rate

= (4*100/(50-10))+5

= 15%

And the company requires 40% debt and 60% equity

So, cost if new money is raised = weighted average cost of debt and equity

= 0.4*8*(1-0.4) + 0.6*15

= 10.92%

So, for the first two Many and Moe, retained earnings can be used since cost <= IRR and for Jack they can issue equity and debt.

B. Capital budget:

Retained earnings used = 2000000

Debt = 400000

Equity = 600000

Part 2

Since there are no retained earnings now.

The 3 projects will be selected and will be financed through debt and equity.

B. Capital budget:

Debt = 40% of 3000000 = 1200000

Equity = 60% of 3000000 = 1800000