Question

Question 4

Acme Publishing has the following (independent) investment opportunities:

Project	Initial investment	IRR
A	$13 000	16%
B	$17 000	14%
C	$10 000	10%

The optimal capital structure calls for financing all projects with 60 per cent ordinary shares and 40 per cent debt. The following information applies to the future financial position of Acme Publishing:

• The most recent dividend (DO) was $0.35
• The growth rate of earnings and dividends is 6 per cent
• The current price of shares is $4.60
• If new shares are issued, a flotation cost of 10% will be incurred
• The company can borrow up to $10,000 from its bank at an interest rate of 12%. For any amount of debt above $10,000, the interest rate is 14%
• The company’s dividend pay out ratio is 40%
• The company is in a 30% tax bracket
• Acme Publishing earned $35,000 last year before tax

Required

In which of the projects (if any) should Acme Publishing invest, and what is its capital budget and weighted average cost of capital (WACC)?

Answer 1

After tax earning- last year = 35000*(1-.4)		21000
% of debt in total capital structure = 40000*40%		16000
Interest on debt value 0f 16000	(10000*12%)+(6000*14%)	2040
interest payent as % of total debt borrowed	2040/16000	12.75%
after tax cost of debt = interest rate*(1- tax rate)	12.75*(1-.4)	7.65
cost of common share new issue =(expected dividend/marke price less flotation cost)+ growth rate	(.371/4.14)+6%	14.96%
expected dividend = current year dividend*(1+growth rate)	.35*1.06	0.371
market price less flotation cost	4.6-(4.6*10%)	4.14
cost of common share - equity =(expected dividend/marke price )+ growth rate	(.371/4.6)+6%	14.07%
expected dividend	.35*1.06	0.371
market price	4.6	4.6
WACC
Source	value of investment	Weight	component cost	weight*component cost
bank loan	16000	0.4	7.65	3.06
common stock-equity	21000	0.525	14.07	7.38675
common stock-new stock	3000	0.075	14.96	1.122
total optimal capital structure	40000			11.57
Project	IRR	WACC	Accept = IRR>WACC reject IRR<WACC	Initial Investment
A	16%	11.57%	Accept	13000
B	14%	11.57%	Accept	17000
C	10%	11.57%	reject	10000
total capital budget				30000