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Investment opportunity Internal rate of return Cost Project H 14.5% Project G 13.0 $200,000
700,000 Project K 12.8 500,000 Project M 11.4 600,000 a. Complete the cost-of-capital schedule by calculating the WACC and the
WMCC schedule for the various ranges of new financing.
b. Identify those projects that you recommend that Grainger Corp. undertake in
the next year.
c. Illustrate your recommendations by drawing a graph of Grainger’s weighted
average costs and investment opportunities similar to Figure 11.2.
d. Explain why certain projects are recommended and other(s) are not. CHAPTER 11 CASE Making Star Products’
Financing/Investment Decision S tar Products Company is a growing manufacturer of automobile accessories
whose stock is actively traded on the over-the-counter exchange. During
2003, the Dallas-based company experienced sharp increases in both sales and
earnings. Because of this recent growth, Melissa Jen, the company’s treasurer,
wants to make sure that available funds are being used to their fullest. Management policy is to maintain the current capital structure proportions of 30%
long-term debt, 10% preferred stock, and 60% common stock equity for at least
the next 3 years. The firm is in the 40% tax bracket.
Star’s division and product managers have presented several competing
investment opportunities to Ms. Jen. However, because funds are limited,
choices of which projects to accept must be made. The investment opportunities
schedule (IOS) is shown in the following table.
Investment Opportunities Schedule (IOS)
for Star Products Company
opportunity Internal rate of
return (IRR) Initial
investment A 15% $400,000 B 22 200,000 C 25 700,000 D 23 400,000 E 17 500,000 F 19 600,000 G 14 500,000 504 PART 4 Long-Term Financial Decisions To estimate the firm’s weighted average cost of capital (WACC), Ms. Jen contacted a leading investment banking firm, which provided the financing cost data
shown in the following table.
Financing Cost Data
Star Products Company
Long-term debt: The firm can raise $450,000 of additional debt by selling 15-year, $1,000-par-value, 9% coupon interest rate bonds that pay
annual interest. It expects to net $960 per bond after flotation costs. Any
debt in excess of $450,000 will have a before-tax cost, kd, of 13%.
Preferred stock: Preferred stock, regardless of the amount sold, can be
issued with a $70 par value and a 14% annual dividend rate and will net
$65 per share after flotation costs.
Common stock equity: The firm expects dividends and earnings per
share to be $0.96 and $3.20, respectively, in 2004 and to continue to
grow at a constant rate of 11% per year. The firm’s stock currently sells
for $12 per share. Star expects to have $1,500,000 of retained earnings
available in the coming year. Once the retained earnings have been
exhausted, the firm can raise additional funds by selling new common
stock, netting $9 per share after underpricing and flotation costs. Required
a. Calculate the cost of each source of financing, as specified:
(1) Long-term debt, first $450,000.
(2) Long-term debt, greater than $450,000.
(3) Preferred stock, all amounts.
(4) Common stock equity, first $1,500,000.
(5) Common stock equity, greater than $1,500,000.
b. Find the break points associated with each source of capital, and use them to
specify each of the ranges of total new financing over which the firm’s
weighted average cost of capital (WACC) remains constant.
c. Calculate the weighted average cost of capital (WACC) over each of the
ranges of total new financing specified in part b.
d. Using your findings in part c along with the investment opportunities schedule (IOS), draw the firm’s weighted marginal cost of capital (WMCC) and
IOS on the same set of axes (total new financing or investment on the x axis
and weighted average cost of capital and IRR on the y axis).
e. Which, if any, of the available investments would you recommend that the
firm accept? Explain your answer. WEB EXERCISE
W Go to the St. Louis Federal Reserve Bank Web site www.stls.frb.org. Click on
Economic Research; click on Fred; click on Monthly Interest Rates; and then
click on Bank Prime Loan Rate Changes—Historic Dates of Changes and
1. What was the prime interest rate in 1934?
2. What is the highest the prime interest rate has been? When was that? CHAPTER 11 The Cost of Capital 505 3. What has been the highest prime interest rate since you were born?
4. What is the present prime interest rate?
5. Over the past 10 years, what was the lowest prime interest rate? What has
been the highest prime interest rate over the past 10 years?
Now go to Barra’s Web site www.barra.com and click on Research
and then on S&P/Barra U.S. Equity Indexes. Indexes 6. What was the average annual 10-year return on large-cap stocks, as measured by growth in the S&P 500 (annualized 10-year return)? How does this
compare to your answers in question 5? Remember to check the book’s Web site at
for additional resources, including additional Web exercises....
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