Question

Suppose you are conducting a marginal WACC analysis to identify your firm’s optimal capital budget. Assume you have $1,500,000 of retained earnings available. The current market price of the common stock is $45.00. The expected dividend for this coming year is projected to be $2.80, increasing thereafter at a 7% annual growth rate. Sale of new common stock will be subject to a 2% discount from the current stock price, and investment banking fees will be $3.75 per share.

Assume your firm has a target capital structure of 25% debt financing and 75% common equity financing. It estimatesthat it can raise $750,000 in debt at a before-tax cost of 9%. Beyond this level of debt, the firm estimates the before-tax cost of debt will increase to 10.5%. The firm’s marginal tax rate is 40%.

The projects that you are considering undertaking are as follows:

Project	Initial Outlay	IRR
A	$1,300,000	13.0%
B	$1,000,000	12.5%
C	$900,000	11.5%
D	$400,000	8.0%

Question 2.1 (15 points): Using a Marginal WACC model, what is your firm’s estimated optimal investment opportunity curve, or choice of projects for investment?

Answer 1

		COST OF EQUITY:
		D1=Next years dividend	$2.80
		g=Annual growth rate=7%	0.07
		Price of common stock	$45.00
		Amount received from new equity:
		Discount =2%*45=	$0.90
		Banking Fees	$3.75
		P0=Net amount received per share	$40.35	(45-0.9-3.75)
		R=Cost of retained Earnings:
		R=(D1/P0)+g=(2.8/45)+0.07	0.13939281
		Cost of New Equity	13.94%
		PROJECT A:
		Initial Outlay	$1,300,000
			W	A	B	C=B*(1-0.4)	D=W*C
			Weight	Amount	Before tax cost	After tax cost	After tax Cost*Weight
		Debt	0.25	$325,000	9%	5.40%	1.35%
		Equity	0.75	$975,000		13.94%	10.45%
						SUM	11.80%
		Marginal WACC=Sum of (Weight*After tax cost)	11.80%
		IRR	13.00%
		PROJECT B:
		Initial Outlay	$1,000,000
			W	A	B	C=B*(1-0.4)	D=W*C
			Weight	Amount	Before tax cost	After tax cost	After tax Cost*Weight
		Debt	0.25	$250,000	9%	5.40%	1.35%
		Equity	0.75	$750,000		13.00%	9.75%
						SUM	11.10%
		Marginal WACC=Sum of (Weight*After tax cost)	11.10%
		IRR	12.50%
		PROJECT C:
		Initial Outlay	$900,000
			W	A	B	C=B*(1-0.4)	D=W*C
			Weight	Amount	Before tax cost	After tax cost	After tax Cost*Weight
		Debt	0.25	$225,000	9%	5.40%	1.35%
		Equity	0.75	$675,000		12.50%	9.38%
						SUM	10.73%
		Marginal WACC=Sum of (Weight*After tax cost)	10.73%
		IRR	11.50%
		PROJECT D:
		Initial Outlay	$400,000
			W	A	B	C=B*(1-0.4)	D=W*C
			Weight	Amount	Before tax cost	After tax cost	After tax Cost*Weight
		Debt	0.25	$100,000	9%	5.40%	1.35%
		Equity	0.75	$300,000		11.50%	8.63%
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