Question

Tex-Mex by Rex, Inc. is planning its yearly budget and has the following potential independent proposals: PROJECT OUTLAY IRR A $5,000,000 11.0% B $5,000,000 18.0% C $8,000,000 16.0% D $12,000,000 10.5% E $12,000,000 12.0% The firm’s capital structure shown below is considered optimal and will be maintained: Debt $80,000,000 Preferred Stock $20,000,000 Common Equity $100,000,000 The firm has a marginal tax rate of 35% and has $5,000,000 of retained earnings available for investment. Four years ago, Tex-Mex by Rex, Inc. paid a common stock dividend of $3.75 a share. Yesterday, they paid a dividend of $5.00. Assume that this dividend growth rate continues for the indefinite future. The market price for its common stock is $82 with a beta of 1.25. Currently, the YTM on T-Bonds is 2% and the expected market return is 10%. Tex-Mex by Rex, Inc. can raise funds under the following limitations: BONDS: New 20-year $1000 par value bonds carrying a coupon of 12% (annual) are priced to yield the investor 10% a year. Flotation costs total $70.27 per bond. PREFERRED STOCK: Current shares of preferred stock have a dividend of $3.50 and are selling for $50 per share. Underwriters charge a flotation fee of 12% of the selling price. COMMON STOCK: New common stock requires flotation costs equal to 13% of the stock’s price.

1) Calculate the Weighted Average Cost of Capital (WACC) for Tex-Mex by Rex, Inc. assuming that they will be utilizing retained earnings rather than any new common stock. 2) Calculate the Weighted Average Cost of Capital (WACC) for Tex-Mex by Rex, Inc. assuming that they will need to issue new common stock. 3) At what total capital expenditure (in $) will this change from the first WACC (with REs) to the second WACC (with new common stock) occur? 4) Which investment project(s) should be accepted? (indicate all that apply)

Answer 1

	COMPONENT COST OF CAPITAL:
a)	Cost of debt:
	Price of the bond with 10% yield = 1000/1.10^20+120*(1.10^20-1)/(0.10*1.10^20) =	$           1,170.27
	Net sale price on new bond = 1170.27-70.27 =	$           1,100.00
	YTM of the bond with net price of 1100 (using an online calculator) =	10.76%
	After tax cost of debt = 10.76%*(1-35%) =	6.99%
b)	Cost of preferred stock:
	= 3.5/(50*88%) =	7.95%
c)	Cost of retained earnings:
	Using constant dividend discount model:
	Growth rate = (5/3.75)^(1/4)-1 = 7.46%
	Cost of retained earnings = 5*1.0746/82+0.0746 =	14.01%
	Using CAPM = 2%+1.25*(10%-2%) =	12.00%
	Average of the above two = (14.01%+12%)/2 =	13.01%
d)	Cost of new equity:
	Using constant dividend discount model:
	'= 5*1.0746/(82*87%)+0.0746 =	14.99%
	Using CAPM = 12.00%/87% =	13.79%
	Average of the above two = (14.99%+13.79%)/2 =	14.39%
1)	WACC (with retained earnings) = 13.01%*50%+7.95%*10%+6.99%*40% =	10.10%
2)	WACC (with new equity) = 14.39%*50%+7.95%*10%+6.99%*40% =	10.79%
3)	The change will occur at 5000000/50% =	$     1,00,00,000
4)	Investment opportunity schedule:
	Project	Initial Outlay	IRR %
	B	5000000	18.0
	C	8000000	16.0
	E	12000000	12.0
	A	5000000	11.0
	D	12000000	10.5
	Total	42000000
	All projects other than D can be accepted.