Question

Closegate toothpaste needs additional capital of $10,000,000 for their new line of toothpaste. The owners are willing to use 20% of their total retained earnings amounting to $15,000,000 which currently bear an interest rate of 15% annually in a security investment. The company plans to offer bonds with face value amounting to $5,000,000 at a total cost of 10% compunded quarterly. The company plans to source the remaining funds through a bank loan that chagres an interest of 20% per annum. The company requires an IRR of 20% for the new line of toothpaste.

A. What is the effective cost of capital of the bonds being offered?

B. What is the MARR of the new toothpaste?

C. Does the MARR satisfy the company's IRR requirement?

Answer 1

Calculation of effective cost of capital of bond-

Given-

Particulars	Amount	Cost %	Remarks
Total capital requirement	10000000
To be taken from retained earnings	3000000	15%	P.A.
Through Bonds	5000000	10%	P.A.Compunded Quarterly
Bank Loan	2000000	20%	P.A.

Formula to calculate effective rate of interest is-

Here R is rate given divided by number of periods in a year so if it is given that compunded quarterly so the rate is divided by 4 becasue in a year 4 quarters are there so in given problem R is 2.5% (10%/4).

Here N is number of periods in a year so in a year total quarters are 4 so N=4

So effective cost of capital is= ((1+0.025)power 4)-1= 0.1038 it means 10.38%

MARR is just weighted average cost of capital that needs to be earn to survive and below is the calculation-

Particulars	Amount	Cost %	Remarks
Total capital requirement	10000000
To be taken from retained earnings	3000000	15%	P.A.
Through Bonds	5000000	10%	P.A.Compunded Quarterly
Bank Loan	2000000	20%	P.A.
Weighted average cost of capital is MARR		13.50%

Note- Weighted average is calculated just by multuplying amount with rate and divided by total amount required for project.

MARR not satsfying company's requiremnt as company wants IRR of 20% which is shortfall by 6.5%