Table 1. Selected Income Statement Items
2004 2005 2006 Projected 2007
Net sales $ 13,860,000 $ 15,940,000 $ 18,330,000 $ 21,080,000
Net profits after taxes 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
Because of the recent growth, Margaret Jennings, the corporate treasurer, is concerned that available funds are not being used to their fullest potential. The projected $ 1,300,000 of internally generated 2007 funds is expected to be insufficient to meet the company’s expansion needs. Management has set a policy of maintaining the current capital structure 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.
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), 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)
Investment opportunity Internal rate of return ( IRR) Initial investment
A 21% $ 400,000
B 19 200,000
C 24 700,000
D 27 500,000
E 18 300,000
F 22 600,000
G 17 500,000
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 has been exhausted, the firm can raise additional funds by selling new common stock, netting $ 16 per share after under- pricing and flotation costs.
1. 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 Range of new financing After- tax cost (%)
Long- term debt $ 0–$ 700,000 ___
$ 700,000 and above ___
Preferred stock $ 0 and above ___
Common stock equity $ 0–$ 1,300,000 ___
$ 1,300,000 and above ___
2. a. Determine the break points associated with each source of capital. b. 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. c. Calculate the weighted average cost of capital for each range of total new financing.
3. a. 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. b. Which, if any, of the available investments would you recommend that the firm accept? Explain your answer.
4. a. Assuming that the specific financing costs do not change, what effect would a shift to a more highly leveraged 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.) b. Which capital structure— the original one or this one— seems better? Why?
5. a. 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? b. Would you recommend an alternative dividend policy? Explain. How would this policy affect the investments recommended in part c( 2)?