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ABC's current capital structure of 60 percent equity, 30 percent debt, and 10 percent preferred stock is considered optimal.

ABC's current capital structure of 60 percent equity, 30 percent debt,
and 10 percent preferred stock is considered optimal. This year ABC expects
to have earnings after tax of $4 million and pay dividends based on its 40%
dividend pay-out ratio.
ABC just paid a dividend of $2.00. Dividends have been growing at an annual
compound rate of 7 percent a year and are expected to continue growing at
that rate. The current market price of ABC stock is $35 and up to $2 million
in new equity can be raised for a flotation cost of 10 percent. If more than
$2 million is sold then the flotation cost will be 15 percent.
Up to $2 million in debt can be sold at par with a coupon rate of 10
percent. An additional $3 million in debt can be sold at par with a coupon
rate of 11%. Any additional debt will carry a 12 percent coupon rate and be
sold at par.
ABC can sell an unlimited amount of preferred stock at a pre-tax cost of
11.5%.
ABC’s marginal tax rate is 40% and it has an opportunity to invest in the
following capital projects. Which one(s) should be accepted? What is ABC’s
optimal capital budget? (Please draw MCC and IOS curves when answering this
question.)
Project $ IRR
A 2,000,000 0.135
B 2,500,000 0.125
C 1,500,000 0.12
D 1,250,000 0.115
E 1,000,000 0.11
F 750,000 0.105
G 500,000 0.1

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