# Assume that kr ks b if earnings available to common

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Unformatted text preview: d the break point calculated in part b. d. Determine the weighted average cost of capital just beyond the break point calculated in part b. LG2 LG3 LG4 LG5 11–16 Calculation of specific costs, WACC, and WMCC Lang Enterprises is interested in measuring its overall cost of capital. Current investigation has gathered the following data. The firm is in the 40% tax bracket. Debt The firm can raise an unlimited amount of debt by selling \$1,000-parvalue, 8% coupon interest rate, 20-year bonds on which annual interest payments will be made. To sell the issue, an average discount of \$30 per bond would have to be given. The firm also must pay flotation costs of \$30 per bond. Preferred stock The firm can sell 8% preferred stock at its \$95-per-share par value. The cost of issuing and selling the preferred stock is expected to be \$5 per share. An unlimited amount of preferred stock can be sold under these terms. Common stock The firm’s common stock is currently selling for \$90 per share. The firm expects to pay cash dividends of \$7 per share next year. The firm’s dividends have been growing at an annual rate of 6%, and this is expected to continue into the future. The stock must be underpriced by \$7 per share, and flotation costs are expected to amount to \$5 per share. The firm can sell an unlimited amount of new common stock under these terms. Retained earnings When measuring this cost, the firm does not concern itself with the tax bracket or brokerage fees of owners. It expects to have available \$100,000 of retained earnings in the coming year; once these retained earnings are exhausted, the firm will use new common stock as the form of common stock equity financing. CHAPTER 11 The Cost of Capital 501 a. Calculate the specific cost of each source of financing. (Round answers to the nearest 0.1%.) Source of capital Weight Long-term debt 30% Preferred stock 20 Common stock equity Total 50 100% b. The firm’s capital structure weights used in calculating its weighted average cost of capital are shown in the table above. (Round answer to the nearest 0.1%.) (1) Calculate the single break point associated with the firm’s financial situation. (Hint: This point results from exhaustion of the firm’s retained earnings.) (2) Calculate the weighted average cost of capital associated with total new financing below the break point calculated in part (1). (3) Calculate the weighted average cost of capital associated with total new financing above the break point calculated in part (1). LG4 LG5 LG6 11–17 Integrative—WACC, WMCC, and IOS Cartwell Products has compiled the data shown in the following table for the current costs of its three basic sources of capital—long-term debt, preferred stock, and common stock equity—for various ranges of new financing. Source of capital Range of new financing Long-term debt After-tax cost \$0 to \$320,000 Preferred stock 6% \$320,000 and above 8 \$0 and above Common stock equity 17% \$0 to \$200,000 20% \$200,000 and above 24 The company’s capital structure weights used in calculating its weighted average cost of capital are shown in the following table. Source of capital Weight Long-term debt 40% Preferred stock 20 Common stock equity Total 40 100% 502 PART 4 Long-Term Financial Decisions a. Determine the break points and ranges of total new financing associated with each source of capital. b. Using the data developed in part a, determine the break points (levels of total new financing) at which the firm’s weighted average cost of capital will change. c. Calculate the weighted average cost of capital for each range of total new financing found in part b. (Hint: There are three ranges.) d. Using the results of part c, along with the following information on the available investment opportunities, draw the firm’s weighted marginal cost of capital (WMCC) schedule and investment opportunities schedule (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). Investment opportunity Internal rate of return (IRR) Initial investment A 19% \$200,000 B 15 300,000 C 22 100,000 D 14 600,000 E 23 200,000 F 13 100,000 G 21 300,000 H 17 100,000 I 16 400,000 e. Which, if any, of the available investments do you recommend that the firm accept? Explain your answer. LG4 LG5 LG6 11–18 Integrative—WACC, WMCC, and IOC Grainger Corp., a supplier of fitness equipment, is trying to decide whether to undertake any or all of the proposed projects in its investment opportunities schedule (IOS). The firm’s cost-of-capital schedule and investment opportunities schedules follow. Cost-of-Capital Schedule Range of new financing 0–\$600,000 Source Weight After-tax cost .50 Preferred stock .10 12.5 Common stock \$600,000–\$1,000,000 Debt 6.3% .40 15.3 .50 Preferred stock .10 12.5 Common stock \$1,000,000 and above Debt 6.3% .40 16.4 Debt .50 Preferred stock .10 12.5 7.8% Common stock .40 16.4 CHAPTER 11 The Cost of Capital 503 Investment Opportun...
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