Question

On January 1, 2019, the total assets of the McGarvey Company were $270 million. The first present capital structure, which follows, is considered optimal. Assume that they have no short-term debt. Long-term debt $135,000,000 Common Equity 135,000,000 Total Liabilities and Equity $270,000,000 New bonds will have a 10% coupon rate and will be sold at par. Common stocks are currently selling at $60 a share, can be sold to net the company $54 a share. Stockholders required rate of return is estimated to be 12%, consisting of a dividend yield of 4% and an expected growth rate of 8% (the next expected dividend is $2.4 so $2.4/$60 = 4%). Retained earnings are estimated to be $15 million. The marginal corporate tax rate is 20%. Assuming that all asset expansion (Gross expenditure plus fixed assets plus related working capital) is included in the capital budget, the amount of the capital budget, ignoring depreciation, is 160,000,000

1. To maintain the present capital structure, how much capital budget must McGarvey finance by equity?

2. How much of the new equity funds needed will be generated internally and externally?

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

4. At what level of capital expenditure will there be a break in Dexter's Marginal Cost of Capital schedule?

5. Calculate WACC.

Show some step by step working please

Answer 1

1.Present capital structure is Long-term debt 50% & Equity 50% ( $ 135 mln. Of the total $ 270 mln.)

so, the$ total of the capital budget , to be financed by equity= $ 160 mln./2= $ 80 mln.

2. Amount of the new equity funds to be generated internally and externally

Given that the

Retained earnings are estimated to be $15 million

so, internally generated equity = $ 15 mln. &

externally generated equity =(80-15)= $ 65 mln.

3. Cost of each of the equity components

Cost of retained earnings, kre---12% (with no new issue)

Cost of equity-new issue, ke= ---(2.4/54)+8%=12.44%

After-tax cost of new debt, kd = Before-tax cost*(1-Tax rate)

ie. 10%*(1-20%)= 8.00%

5. WACC=(wt.re*kre)+(wt.e*ke)+(wtd*kd)

ie.(15/160*12%)+(65/160*12.44%)+(80/160*8%)=

10.18%

4.Break-point in marginal cost of capital (level of CAPEX)

Share of retained earnings= $ 15 ml.. Maximum , in any expenditure

Currently, its wt. in the capital structure= 15 mln./160 mln= 9.38%

The capital expenditure , if that requires more than $ 15 mln. From retained earnings ---

will necessitate issue of new equity at 12.44%

so that CAPEX which requires a jump in the WACC, will be the break point

so, $ 15 equity +$ 15 debt= (50% each)= $ 30 mln.is the break point for MCC

CAPEX above 30 mln. Will require issue of new equity, which will cost its wt.*12.44% ,additionally