Question

Corporate Finance

Part A

Assume that Company AZ uses the following sources of capital with the associated information:

Debt: It can issue a 30-year bond with an 8.5% coupon rate paying interest semi-annually at a price of $ 818.35.

Common Stock Equity:

The current price of its stock is $ 19.50, the expected dividend for next year is $ 1.53, and the estimated growth rate is 7 percent.

The firm’s beta is 1.75, the required return on the market is 11%, and the risk free rate is 6.0%.

Flotation costs of 10% per share will be incurred on new common stock issues.

Preferred Stock Equity:

New 10% preferred stock can be sold at $65 per share.

Flotation costs for new preferred stock issues is $3.00 per share.

The firm's marginal tax rate is 40%

The firm has a target capital structure of 35% debt, 5% preferred stock, and 60% common stock. It has $ 22,500,000 of new retained earnings. Should the firm raise more than $17,500,000 in debt, the before tax cost of debt will increase to 14 percent. Determine the WMCC and the ranges over which the WMCC applies.

Part B

Assume Company AZ is considering the follow projects for adoption:

Initial Cost$
Project	Mil	IRR
A	10	15.4%
B	5	11.8%
C	12	14.7%
D	13	12.8%
E	12	12.0%
F	8	14.0%

Which projects should be implemented?

Answer 1

A.

Calculating the YTM for the bond

Using excel function = Rate(nper, pmt, pv, [fv], [type], [guess]) * 2

where nper = 30*2 = 60 periods

pmt = 8.5%*1000 / 2 = $42.5 per period

pv = -$818.35

fv = 100,

type = 0 (at the end of period)

Cost of equity = 6% + 1.75*(11% - 6%) = 14.75% (from CAPM)

Rate of preferred stock = Preferred dividend / Price of preferred stock

Assuming FV of preferred stock = $100, Dividend = 10% of FV = $10

Therefore, Rate of preferred stock = 10 / 65 = 15.38%

Therefore WACC = 0.35 * 10.5% * (1-0.4) + 0.6 * 14.75% + 0.05 * 15.38% = 2.205% + 8.85% + 0.769% = 11.825%

we get, r = 10.5%

At $17.5 million debt, to maintain target capital structure of 35% debt, total funds needed to be raised (including debt, equity, preferred equity) would be = $17.5 million / 0.35 = $50 million

WMCC = 0.35 * 14% * (1-0.4) + 0.6 * 14.75% + 0.05 * 15.38% = 2.94% + 8.85% + 0.769% = 12.559%

This WMCC will exist when additional debt raised is more than $17.5 million and total capital raised is $50 million

B. With $50 million capital raised (based on Part A), projects B, C, D, E should be chosen as the total cost of these projects = $50 million and is the most optimum use of investments with highest total IRR