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.