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On January 1 , 2009 the total assets of the Shipley Company were $ 180 million.During...

On January 1 , 2009 the total assets of the Shipley Company were $ 180 million.During the year, the company plans to raise and invest $ 90 million.The firm’s present capital structure is considered optimal.Assume that there is no short term debt.

Long term debt 90,000,000

Common Equity 90,000,000

Total Liabilities and Equity 180,000,000

New bonds will have a coupon rate of 10% and will sell at par. Common stock,currently selling at $ 40 a share can be sold to net the company at$36 a share. Stockholders’ required rate of return is 12%.( The next expected dividend is $1.60). Retained earnings are estimated to be $9 million.The tax rate is 40%.

a.To maintain the present capital structure, how much of the capital budget must

Shipley finance by equity?

b.How much of the new equity funds needed must be generated

internally?Externally?

c.Calculate the cost of each of the equity components.

d.Calculate the weighted average cost of capital.

Expert Solution

The present Debt to equity ratio= 90000000/ 90000000=1:1

a. So, 90 mln.*50%= 45 mln.should be financed by Equity

Balance 90-45 = 45000000 should be the total equity

b. Current retained earnings in the total common equity= 9000000

so, common equity= 90000000-9000000= 81000000

ie. Retained Earnings :Common Equity= 1/10:9/10 or 1:9

Proceeding in the same ratio,

Internal equity or Retained earnings raised should be 1/10*45000000=

4500000

External equity raised should be 9/10*45000000=

40500000

c.Cost of each of the components

Cost of Retained Earnings=12%

Stockholders' Reqd. rate of return = 12%

Cost of new common stock

Using Gordon's DDM, we find the growth rate as foolws:

Where, Cost of Equity=(Next dividend/Current mkt.price)+Growth rate g

ie.12%=(1.6/40)+g

g=12%-(1.6/40)

8%

Now, applying this growth rate g=8%

we find the cost of new issue which nets only $ 36

ie. Ke=(1.6/36)+8%

12.44%

So, Cost of new common stock= 12.44%

After-tax Cost of debt= Before-tax cost*(1-Tax Rate)

ie. 10%*(1-40%)=

6%

Now, finding the WACC for raising the $ 90 mln.

WACC=

(Wt.d*Kd)+(Wt.e*ke)+(Wt.re*K re)=

(50%*6%)+(45%*12.44%)+(5%*12%)=

9.20%

Alternately,
Type of capital	Amt.	Wt. to total	Cost	Wt.*Cost
External equity	40500000	0.45	12.44%	0.056
Retained earning	4500000	0.05	12.00%	0.006
Debt	45000000	0.5	6%	0.03
Total	90000000	1	WACC=	9.20%

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