Question

On January 1, the total market value of the Tysseland Company was $60 million. During the year, the company plans to raise and invest $25 million in new projects. The firm's present market value capital structure, here below, is considered to be optimal. There is no short-term debt.

Debt	$30,000,000
Common equity	30,000,000
Total capital	$60,000,000

New bonds will have an 9% coupon rate, and they will be sold at par. Common stock is currently selling at $30 a share. The stockholders' required rate of return is estimated to be 12%, consisting of a dividend yield of 4% and an expected constant growth rate of 8%. (The next expected dividend is $1.20, so the dividend yield is $1.20/$30 = 4%.) The marginal tax rate is 40%.

1. In order to maintain the present capital structure, how much of the new investment must be financed by common equity? Write out your answers completely. For example, 13 million should be entered as 13,000,000. Round your answer to the nearest dollar.

   $   

2. Assuming there is sufficient cash flow for Tysseland to maintain its target capital structure without issuing additional shares of equity, what is its WACC? Round your answer to two decimal places.
     %
3. Suppose now that there is not enough internal cash flow and the firm must issue new shares of stock. Qualitatively speaking, what will happen to the WACC? No numbers are required to answer this question.
   I. r_s and the WACC will decrease due to the flotation costs of new equity.
   II. r_s will increase and the WACC will decrease due to the flotation costs of new equity.
   III. r_s will decrease and the WACC will increase due to the flotation costs of new equity.
   IV. r_s and the WACC will not be affected by flotation costs of new equity.
   V. r_s and the WACC will increase due to the flotation costs of new equity.
   -Select-IIIIIIIVVItem 3

Answer 1

a). Weight of Equity = Equity/Total Capital

Equity =$30,000,000

Total MV =60,000,000

Weight of Equity =50.00%

Investment to be financed by Common equity = 0.50 x $25,000,000 = $12,500,000

b). WACC = (Weight of Equity x Cost of Equity) + (Weight of Debt x After Tax Cost of Debt)

r = (D1/P0) + g

= (1.20 /30) + 8% = 4% + 8% = 12%

After Tax Cost of Debt = 9%(1 - 0.40) = 5.60%

WACC = [0.12 x 0.50] + [0.056 x 0.50] = 0.06 + 0.028 = 0.088, or 8.8%

c). The answer is V.

When there are flotation costs, the cost of new equity is higher than the cost of retained earnings. Therefore, issuing new stocks will increase the overall cost of equity. It will also increase the weighted average cost of capital for two reasons: (1) equity represents a higher share of total assets now, which increases the weighted average cost of capital because the cost of debt is usually lower; (2) the cost of equity is higher than before.