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fullest. The projected $1,300,000 of internally generated 2004 funds are
expected to be insufficient to meet the company’s expansion needs.
Management has set a policy of maintaining the current capital structure O Table 1
Selected Income Statement Items
2001 2002 2003 Projected
2004 $13,860,000 $15,940,000 $18,330,000 $21,080,000 1,520,000 1,750,000 2,020,000 2,323,000 Earnings per share (EPS) 2.88 3.28 3.84 4.40 Dividends per share 1.15 1.31 1.54 1.76 Net sales
Net profits after taxes 590 proportions of 25% long-term debt, 10% preferred stock, and 65% common stock equity for at least the next 3 years. In addition, it plans to continue paying out 40% of its earnings as dividends. Total capital expenditures are yet to be determined.
Ms. Jennings has been presented with several competing investment
opportunities by division and product managers. However, because
funds are limited, choices of which projects to accept must be made. The
investment opportunities schedule (IOS) is shown in Table 2. To analyze
the effect of the increased financing requirements on the weighted average cost of capital (WACC), Ms. Jennings contacted a leading investment
banking firm that provided the financing cost data given in Table 3.
O’Grady is in the 40% tax bracket.
Investment Opportunities Schedule (IOS)
opportunity Internal rate
of return (IRR) Initial
investment A 21% $400,000 B 19 C 24 700,000 D 27 500,000 E 18 300,000 F 22 600,000 G 17 500,000 200,000 Table 3
Financing Cost Data
Long-term debt: The firm can raise $700,000 of additional debt by selling 10-year,
$1,000, 12% annual interest rate bonds to net $970 after flotation costs. Any debt in
excess of $700,000 will have a before-tax cost, kd, of 18%.
Preferred stock: Preferred stock, regardless of the amount sold, can be issued with a $60
par value and a 17% annual dividend rate. It will net $57 per share after flotation costs.
Common stock equity: The firm expects its dividends and earnings to continue to grow at
a constant rate of 15% per year. The firm’s stock is currently selling for $20 per share. The
firm expects to have $1,300,000 of available retained earnings. Once the retained earnings
have been exhausted, the firm can raise additional funds by selling new common stock, netting $16 per share after underpricing and flotation costs. 591 Required
a. Over the relevant ranges noted in the following table, calculate the after-tax
cost of each source of financing needed to complete the table. Source of capital
Long-term debt Range of new financing After-tax cost (%) $0–$700,000
$700,000 and above Preferred stock
Common stock equity $0 and above
$1,300,000 and above b. (1) Determine the break points associated with each source of capital.
(2) Using the break points developed in part (1), determine each of the
ranges of total new financing over which the firm’s weighted average
cost of capital (WACC) remains constant.
(3) Calculate the weighted average cost of capital for each range of total
c. (1) Using your findings in part b(3) with the investment opportunities
schedule (IOS), draw the firm’s weighted marginal cost of capital
(WMCC) schedule and the IOS on the same set of axes, with total new
financing or investment on the x axis and weighted average cost of capital and IRR on the y axis.
(2) Which, if any, of the available investments would you recommend that
the firm accept? Explain your answer.
d. (1) Assuming that the specific financing costs do not change, what effect
would a shift to a more highly levered capital structure consisting of
50% long-term debt, 10% preferred stock, and 40% common stock
have on your previous findings? (Note: Rework parts b and c using these
capital structure weights.)
(2) Which capital structure—the original one or this one—seems better?
Why? 592 e. (1) What type of dividend policy does the firm appear to employ? Does it
seem appropriate given the firm’s recent growth in sales and profits and
given its current investment opportunities?
(2) Would you recommend an alternative dividend policy? Explain. How
would this policy affect the investments recommended in part c (2)? 593...
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