Question

XYZ Company has 40% debt 60% equity as optimal capital structure. The nominal interest rate for the company is 12% up to $5 million debt, above which interest rate rises to 14%. Expected net income for the year is $17,5 million, dividend payout ratio is 45%, last dividend distributed was $4,5/share, P0 = $37, g=5%, flotation costs 10% and corporate tax rate is 40%.

a. Find the break points

b. Calculate component costs (cost of each financing source)

c. Calculate WACCs.

d. Two projects are available: 1 st. Project requires 15 million initial investments, IRR=18% 2 nd. Project requires 10 million initial investments, IRR=12%

Please find the optimal capital budget. (Project(s) to be invested in)

Answer 1

a]	Retained earnings [available for capital budget] = 17.5*(1-45%) =	$              9.625	Million
	Retained earnings break point = 9.625/60% =	$           16.042	Million
	Debt break point = 5/40% =	$           12.500	Million
	So,
	First break point [Debt]	$           12.500	Million
	Second break point [Retained earnings]	$           16.042	Million
2]	After tax cost of debt within 1st break point = 12%*(1-40%) =	7.20%
	After tax cost of debt after 1st break point = 14%*(1-40%) =	8.40%
	Cost of retained earnings = 4.5*1.05/37+0.05 =	17.77%
	Cost of new common equity = 4.5*1.05/(37-3.7)+0.05 =	19.19%
	WACC:
	Upto 1st break point = 7.20%*40%+17.77%*60% =	13.54%
	Between 1st break point and 2nd break point = 8.40%*40%+17.77%*60% =	14.02%
	Beyond 2nd break point = 8.40%*40%+19.19%*60% =	14.87%
3]	2nd Project cannot be accepted as it has IRR<WACC at all levels.
	1st Projected can be implemented.
	The optimal capital budget would be	$              15.00	Million
	It would be financed by:
	Debt = 15*40% =	$                6.00	Million
	Equity = 15*60% =	$                9.00	Million
	Debt would be $5 million at 12% [before tax] and $1 million [before tax]
	Equity would be from retained earnings [available RE = $9.625 million]