The management of Ferri Phosphate Industries (FPI) is planning next year\'s capi

Question

The management of Ferri Phosphate Industries (FPI) is planning next year's capital budget. FPI projects its net income at $7,500, and its payout ratio is 30 percent. The company's earnings and dividends are growing at a constant rate of 5 percent, the last dividend paid, D0. was $0.90, and the current stock price is $8.59. FPI's new debt will cost 14 percent. If FPI issues new common stock, flotation costs will be 20 percent. FPI is at its optimal capital structure, which is 40 percent debt and 60 percent equity, and the firm's marginal tax rate is 40 percent. FPI has the following independent, indivisible, and equally risky investment opportunities: Project cost Expected Return A $15,000 17% B 20,000 14 C 15,000 16 D 12,000 15 What is FPI's optimal capital budget?

Explanation / Answer

Using the Gordon growth model the company's cost of equity is 8.59= .90*(1.05)/(r-.05) Solving for r we get 16%. The company's after tax cost of debt is 14% *(1-.4)= 8.4% So the overall cost of capital is 8.4 *.4 +16*1.2*.6= 14.88%. Since the expected return on projects A, C, and D exceed 14.88 the budget is (15,000+ 15,000+12,000)= 42,000.

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