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Longstreet Communications, Inc. (LCI), has the following capital structure, which it considers to be optimal:

3. Longstreet Communications, Inc. (LCI), has the following capital structure, which it considers to be optimal:

Debt 25%
Preferred stock 15
Common stock 60
100%

LCI’s net income expected this year is $17,142.86; its established dividend payout ratio is 30%; its tax rate is 40%; and investors expect earnings and dividends to grow at a constant rate of 9% in the future. LCI paid a dividend of $3.60 per share last year (D0), and it’s stock currently sells at a price of $60 per share. Treasury bonds yield 11%; an average stock has a 14% expected rate of return; and LCI’s beta is 1.51. These terms would apply to new security offerings:

Common: New common stock would have a flotation cost of 10%.

Preferred: new preferred would be sold to the public at a price of $100 per share, with a dividend of $11. Flotation costs of $5 per share would be incurred.

Debt: Debt could be sold at an interest rate of 12%

a. Find the component costs of debt, preferred stock, retained earnings, and new common stock.
b. How much new capital can be raised before LCI must sell new equity? (In other words, find the retained earnings break point.)
c. What is the WACC when LCI meets its equity requirement with retained earnings? With new common stock?
d. Construct a graph showing LCI’s MCC schedule.

This question was asked on Mar 16, 2010.

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