Question

Unit 6 Case (Gitman Chapter 9)

Making Star Products’ Financing/Investment Decision

Star Products Company is a growing manufacturer of automobile accessories whose stock is actively traded on the over-the-counter (OTC) market. During 2012, the Dallas-based company experienced sharp increases in both sales and earnings. Because of this recent growth, Melissa Jen, the company’s treasurer, wants to make sure that available funds are being used to their fullest. Management policy is to maintain the current capital structure proportions of 30% long-term debt, 10% preferred stock, and 60% common stock equity for at least the next 3 years. The firm is in the 40% tax bracket.

Star’s division and product managers have presented several competing investment opportunities to Jen. However, because funds are limited, choices of which projects to accept must be made. Star’s current investment opportunities are shown in the table below.

Investment Opportunities for Star Products Company Investment opportunity Internal rate of return (IRR)
Initial investment A 15% $400,000 B 22 200,000 C 25 700,000 D 23 400,000 E 17 500,000 F 19 600,000 G 14 500,000

To estimate the firm’s weighted average cost of capital (WACC), Jen contacted a leading investment banking firm, which provided the financing cost data shown in the following table.

Financing Cost Data Star Products Company Long-term debt: The firm can raise $450,000 of additional debt by selling 15-year, $1,000par-value, 9.0% coupon interest rate bonds that pay annual interest. It expects to net $960 per bond after flotation costs. Any debt in excess of $450,000 will have a before-tax cost, rd , of 13.0%. Preferred stock: Preferred stock, regardless of the amount sold, can be issued with a $70 par value and a 14.0% annual dividend rate and will net $65 per share after flotation costs. Common stock equity: The firm expects dividends and earnings per share to be $0.96 and $3.20, respectively, in 2013 and to continue to grow at a constant rate of 11.0% per year. The firm’s stock currently sells for $12.00 per share. Star expects to have $1,500,000 of retained earnings available in the coming year. Once the retained earnings have been exhausted, the firm can raise additional funds by selling new common stock, netting $9.00 per share after underpricing and flotation costs.

To Do a. Calculate the cost of each source of financing, as specified: (1) Long-term debt, first $450,000. (2) Long-term debt, greater than $450,000. (3) Preferred stock, all amounts. (4) Common stock equity, first $1,500,000. (5) Common stock equity, greater than $1,500,000. b. Calculate Star’s weighted average cost of capital (WACC) for each of the following situations: (1) Long-term debt less than $450,001 and common stock equity less than $1,500,001. (2) Long-term debt greater than $450,000 and common stock equity less than $1,500,001. (3) Long-term debt greater than $450,000 and common stock equity greater than $1,500,000. c. Answer the following questions while considering Star’s current capital structure and your answers to part (b). Be sure to explain your answers. (1) How much long-term debt can Star use before affecting its cost of common stock? (2) What is the maximum amount of financing that Star can raise without using the more expensive new common stock? (3) In part (b), why were you not asked to calculate Star’s WACC when long-term debt is less than $450,001 and common stock equity is greater than $1,500,000? d. Regardless of Star’s WACC, rank the projects according to most attractive to least attractive and explain your ranking procedure. e. Based on the current capital structure and each of the financing scenarios below, determine which investment opportunities Star should undertake. Explain your answers. (1) Long-term debt of $450,000. (2) Common stock equity of $750,000. (3) Common stock equity of $1,500,000. (4) Long-term debt of $1,000,000.

Please answer every question clearly!

Answer 1

a-1). Cost of long-term debt < 450,000

Before tax cost of debt (rd) = [Interest + (1,000 - Nd)/n]/[(Nd + 1,000)/2] where Nd = net proceeds = 960; n = number of years to maturity = 15; I = annual interest = annual coupon rate*par value = 9%*1,000 = 90

rd = [90 + (1,000-960)/15]/[(960+1,000)/2] = 9.46%

After-tax cost of debt = rd*(1-Tax rate) = 9.46%*(1-40%) = 5.68%

a-2). Cost of long-term debt > 450,000 = rd*(1-tax rate) = 13%*(1-40%) = 7.80%

a-3). Cost of preferred stock (kps) = annual dividend/net proceeds per share = (annual dividend rate*par value)/net proceeds per share

= (14%*70)/65 = 15.08%

a-4). Cost of common equity <= 1,500,000:

kre = (D1/P0) + g = (0.96/12) + 11% = 19.00%

a-5). of common equity > 1,500,000:

ke = (D1/Np) + g = (0.96/9) + 11% = 21.67%

b). Breaking point for long-term debt = 450,000/debt ratio in capital structure = 450,000/30% = 1,500,000

Breaking point for common equity = 1,500,000/equity ratio in capital structure = 1,500,000/60% = 2,500,000

WACC = (debt ratio*after-tax cost of debt) + (preferred stock ratio*cost of preferred stock) + (equity ratio*cost of equity)

WACC (for total capital from 0 to 1,500,000) = (30%*5.68%) + (10%*15.08%) + (60%*19%) = 14.61%

WACC (for total capital from 1,500,001 to 2,500,000) = (30%*7.80%) + 10%*15.08%) + (16%*19.00%) = 15.25%

WACC (for total capital above 2,500,000) = (30%*7.80%) + 10%*15.08%) + (16%*21.67%) = 16.85%

c-1). Cost of common stock changes when total capital requirement is above 2,500,000 so maximum debt which can be used before cost of common stock is affected is 30%*2,500,000 = 750,000

c-2). Again, new common stock is used when total capital requirement is above 2,500,000 so maximum financing which can be raised without using new common stock is 2,500,000.

c-3). If long-term debt is less than 450,001 and common equity is more than 1,500,000 then the target capital structure will not hold.

d). Projects with IRRs greater than the WACCs calculated can be accepted as they will result in profits. So, projects B, C, D, E, F can be accepted. Ranking will be based on the IRRs so it will be descending order of IRRs.

Ranking: C, D, B, F, E

e-1). Long-term debt of 450,000: Total capital is1,500,000 so B,C,D can be financed as the total investment required will be 1,300,000 which is less than 1,500,000.

e-2). Common equity of 1,500,000: Total capital is 2,500,000 so along with B, C & D, projects E & F can also be financed at total investment will be 2,400,000 which is less than 2,500,0000.

e-3). Long-term debt of 1,000,000: At this level of long-term debt, total capital will be 1,000,000/30% = 3,333,333.33 so total project investment of 2,400,000 is less than this so this level of financing won't be required.