finNotesCostCapital

# finNotesCostCapital - COST OF CAPITAL The Problem Step 1:...

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COST OF CAPITAL The Problem Step 1: Computing the Component Costs Step 2: Computing the Break Points Step 3: Computing the Weighted Marginal Cost of Capital Step 4: Comparing IRR vs. MCC Step 5: Computing the Weighted Average Cost of Capital Step 6: Computing the NPV of Project B The Problem On January 1, 1997 Bunky's Burgers, Inc. is planning its yearly capital budget and is faced with a list of 5 potential independent proposals: PROJECT OUTLAY IRR A 8,000,000 14.0% B 8,000,000 21.0% C 10,000,000 19.0% D 12,000,000 13.5% E 12,000,000 16.0% The firm's capital structure relations shown below are considered optimal and will be maintained: Debt \$120,000,000 Preferred Stock 20,000,000 Common Equity 60,000,000 TOTAL CLAIMS \$200,000,000 The firm has a marginal tax rate of 35% and has \$4,500,000 from internal sources of equity available for investment. Four years ago Bunky's paid a common stock dividend of \$5.545 a share. Yesterday they paid a dividend of \$7.00. Assume that this dividend growth rate continues for the indefinite future. The common stock is currently priced to produce a dividend yield (based on the next dividend) of 18%. Bunky's can raise new funds under the following conditions: BONDS: (Up to \$24,000,000) New 20 year \$1000 par value bonds carrying a coupon of 12 per cent (payable annually) are priced to yield the investor 10% a year. Flotation costs total \$70.27 per bond. (Beyond \$24,000,000) A second issue of 20 year 12 per cent coupon bonds can be sold to yield the investor 14% a year. Flotation costs total \$67.54. PREFERRED STOCK: Any size issue of new preferred stock can be sold to yield the investor 16%. Underwriters charge a fee of 20% of the selling price. COMMON STOCK: Issuing up to \$7,500,000 of new common stock requires underpricing and flotation costs equal to 20% of the stock's price. Beyond \$7,500,000 requires flotation costs equal to 30% of the selling price.

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{a} Which projects should Bunky's accept? Your analysis must include the calculation of the marginal cost of capital along all of the various segments. CLEARLY display your MCC and IRR results on a CAREFULLY labeled LARGE graph. (Carry all calculations to four decimal places; e.g., .1234 or 12.34%). {b} What is the weighted average cost of capital for the capital budget you are advocating in part {a}? {c} Compute the NPV of project B. Assume uniform cash flows and a life of 6 years. {d} If Bunky's cost of equity is so much more than its cost of debt, how can it think raising nearly half of its funds from equity is "optimal"? Step 1: Component Costs The first step in a cost of capital problem is to find the costs of the individual components. Let's start with new debt or bonds. The firm can raise up to \$24,000,000 by selling new bonds with the following characteristics: maturity of 20 years (and since the coupon is paid annually, we keep n as 20 years rather than our usual doubling to 40 semi-annual periods--don't do that if interest is paid annually); coupon of 12% or
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## This note was uploaded on 02/07/2011 for the course FIN 125 taught by Professor Buell during the Spring '08 term at Lehigh University .

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finNotesCostCapital - COST OF CAPITAL The Problem Step 1:...

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