Question

In: Finance

On 1 January 2019, the total assets of the Dexter Company were $270 million. The company’s...

On 1 January 2019, the total assets of the Dexter Company were $270 million. The company’s present capital structure, which follows, is considered to be optimal. Assume that there is no short-term debt.

Long-term debt $ 135,000,000
Ordinary equity $135,000,000
Total liabilities and Equity $270,000,000

The company is considering an investment in a new capital investment project. Assuming that all asset expansion (gross expenditures for fixed assets plus related working capital) is included in the capital budget, the dollar amount of the capital budget, ignoring depreciation, is $135 million.

Fund management for the project is given below:  

New bonds will have a 10 percent coupon rate and will be sold at par. Ordinary shares, currently selling at $60 a share, can be sold to net the company $54 a share. Shareholders’ required rate of return is estimated to be 12 percent, consisting of a dividend yield of 4 percent and an expected growth rate of 8 percent. (The next expected dividend is $2.40, so $2.40/$60 = 4%.) Retained earnings are estimated to be $13.5 million. The marginal tax rate is 40 percent.

  1. To maintain the present capital structure, how much of the capital budget must Dexter finance by equity? How much of the new equity funds needed will be generated internally? Externally? ( 1.5 marks)
  2. Calculate the WACC by considering new equity costs and new debt costs.

Solutions

Expert Solution

Answer-(1)

Current capital structure = 50% debt and 50% Equity

To maintain the present capital structure, finance by equity = Total capital budget * 0.50

=> $135000000*0.5 = $67,500,000

---------------------------------------------------------------

Answer-(2)

Internally generated Equity = Expected retained earnings = $13.50 million or $13,500,000

Externally generated Equity needed = Total Equity needed - Internally generated Equity

=>$67,500,000-$13,500,000 = $54,000,000

-----------------------------------

Answer-(3)

Cost of Debt = Coupon rate *(1- tax rate ) = 10% * (1-0.40)= 6%

Cost of retained Earnings = Dividend yield + Growth rate = 4% +8% = 12%

Cost of new equity =

=> Cost of new equity =

=> Cost of new equity = 12.44%.

A B A*B
Amount issued Weight Cost Weighted cost
Debt 67500000 0.500 6% 3.00%
Retained earnings 13500000 0.100 12% 1.20%
New equity 54000000 0.400 12.44% 4.98%
Total 135000000 WACC 9.18%

Hence WACC of new capital investment = 9.18%.

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