Today's market is subject to different supply and demand factors and underlying economic events than when Orbit's capital structure was put in place. This has been translated into the following current yields, which are demanded by the marketplace for a company exhibiting the same risk characteristics as Orbit Corp.:
- The bank's prime rate is now 9.5 percent. The average yield on 91-day T-bills is now 8.5 percent.
- Subordinated debentures would now demand 12 percent; the underwriter would float them for 5 percent of par.
- Preferreds would now call for a stated yield of 11 percent. The underwriters would take 6 percent of issue price for their fee.
- Orbit's stock currently trades on the market at $25. Flotation costs would be 8 percent of the current market price.
This high-growth stock, 12 percent per year, pays no dividends but it has been determined to have a beta of 1.7. A well-diversified market portfolio of stocks would yield excess returns of 9 percent above the risk-free rate of interest in the foreseeable future.
Retained earnings will be insufficient to contribute the equity portion of funding of new investments. Orbit's tax rate is 23 percent.
- Calculate Orbit's cost of capital.
- Would you suggest that Orbit consider paying a small dividend?
- Explain how Orbit might improve its capital structure. Justify your position.