Grey Matter, Inc. is planning its 2015 capital budget and needs your advice. The
ID: 2651634 • Letter: G
Question
Grey Matter, Inc. is planning its 2015 capital budget and needs your advice. The firm believes that the capital relations shown below are optimal and will be maintained.
The firm has a marginal tax rate of 40% and has $6,000,000 of retained earnings available for investment this year. On June 26, 2011 Grey Matter paid a dividend of $7.626 on its common stock. Yesterday (June 26, 2014) it paid a dividend of $9.607. The stock is currently selling for $80 a share. Assume that this growth rate continues indefinitely. The firm can raise funds under these conditions:
BONDS: Up to $9,900,000 in new bonds can be sold at a before tax cost of 12%. Beyond $9,900,000 the before tax cost jumps to 15%.
PREFERRED STOCK: Up to $10,000,000 in $100 par preferred stock with a dividend rate of 16% can be sold at $96 a share with flotation costs of $7.11. Beyond $10,000,000 the flotation costs rise to $24.89 a share.
COMMON STOCK: Up to $6,500,000 in new common stock can be sold to net the firm $61.035 a share. Beyond $6,500,000 the net proceeds total only $51.88.
The firm is considering five potential projects with the following forecasted cash flows:
{a} Compute Grey Matter’s marginal cost of capital for each segment of the marginal cost schedule.
{b} Clearly demonstrate using a CLEARLY LABELED graph which projects are acceptable and compute the average cost of capital for the capital budget you are advocating.
{c} Explain the difference between the current common stock price of $80 and the $61.035 net proceeds from the sale of the first $6,000,000 of new stock.
{d} Compute the net-present value of Project Z. Clearly indicate what discount rate you are using.
{e} If the cost of equity is so much greater than the cost of debt, why does the firm still use so much equity?
Debt $660,000,000 Preferred Stock $240,000,000 Common Equity $300,000,000 TOTAL CLAIMS $1,200,000,000Explanation / Answer
Cost of common capital:
Dividend paid in June 2011 =$7.626.
Dividend paid in June 2014=$9.607
Increase in dividend =$9.607 - $7.626.=1.981.
% of increase in dividend for 3 years=1.981/7.626*100 =0.2597692*100 =25.9769%.
Average growth rate per year=25.9769%/3 =8.659%
Dividend expected to be paid next year=$9.607 *108.659% =$10.4388 rounded to $10.439.
Cost of common funds =( D1/P0)+g
D1is the dividend expected to be paid next year. =$10.439
P0 is the current price.=$80.
g is the growth rate=8.659%.
Substituting the values in the above said formula Cost of capital = ($10.439/$80)+8.659%
=21.708%.
Cost of debt:
Given cost of debt before tax for funds borrowed below 9,900,000 is 12%.
Tax rate=40%.
After tax cost of debt = 12%(1-0.40)
=12% *0.60
=7.2%.
Cost of debt before tax if the borrowing exceeds 9,900,000 is 15%.
After tax cost of debt=15%(1-0.40)
=9%.
Cost of preferrred stock:
Preference divided up to $1 million =16%.
Price of the share =$96.
Flotation costs=7.11.
Cost of preferred stock= Preferred stock/(Funds received - Flotation costs)
Preference divided of a $100 par value stock= 16%.
Substituting the values in the formula = 16/(96-7.11)
=(16/88.89)*100
=17.9997% rounded to 18%
Cost of preferred debt if the capital to be raised is more than $1 million:
Flotation costs=24.89.
cost of preferred debt =16/(96-24.89)
=16/71.11
=0.225003 *100
=22.5%.
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.