In: Finance
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.
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
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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
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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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