Saint Leo Manufacturing is going to introduce a new product line and to accompli
ID: 2677676 • Letter: S
Question
Saint Leo Manufacturing is going to introduce a new product line and to accomplish thisit has four projects analyzed in which it wants to invest a total of $100 million. Your job is to
find what it will cost to raise this amount of capital and based on the cost of capital determine which of the
projects should be accepted by the firm to invest in.
PROJECTS
A B C D
INVESTMENT $30,000,000 $20,000,000 $25,000,000 $25,000,000
EXPECTED RETURN 10.00% 14.00% 11.50% 16.00%
The firms capital structure consists of: FMV
CAPITAL PERCENTAGE AMOUNT
DEBT 30% $15,000,000
PREFERRED STOCK 10% $5,000,000
COMMON STOCK 60% $30,000,000
$50,000,000
Other information about the firm:
CORPORATE TAX RATE 30%
DEBT
CURRENT PRICE $1,050.00
ANNUAL INTEREST 6.00% CURRENT INTEREST PAID SEMIANNUALLY
ORIGINAL MATURITY 25 YEARS, BUT NOW 20 YEARS LEFT
MATURITY VALUE $1,000.00
FLOTATION COST INSIGNIFICANT
MARKET YIELD PROJECTED:
UP TO $20 MILLION 9%
ABOVE $20 MILLION 12% 3 % additional premium
PREFERRED
CURRENT PRICE $45.00
LAST DIVIDEND (D0) $3.38 FIXED AT 7.5% OF PAR
FLOTATION COST $1.50
NEXT DIVIDEND (D1) $3.38
COMMON
CURRENT PRICE $35.00
LAST DIVIDEND (D0) $1.00
RETAINED EARNINGS $10,000,000
GROWTH RATE (g) 9%
FLOTATION COST $1.50
NEXT DIVIDEND (D1) $1.090
NOTE - Once retained earnings is maxed out new common stock will need to be issued.
Any preferred stock would be new preferred stock. You may want to review case in chapter 11.
REQUIRED:
In all of the required parts one part builds on the previous part. If you can't do a part use the
set of other numbers to solve the next part.
a. What is the current Kd, Kp and Ke assuming no new debt or stock?
b. Since any new capital investment will require issuing new perferred stock, what would the
the new returns be preferred stock (knp) and the new cost of capital?
c. What amount of increase (marginal cost of capital) in capital structure will the firm run
out of retained earnings and be forced to issue new common stock?
d. If new common stock has to be issued what will the new return required be (Kne) and the
new cost of capital?
Note: All Answers Should Be Taken Out to 2 Decimal Places, Especially the Interest Rate Answers.
Part a
Current price
Maturity value
Interest payment
Payment periods
Yield rate six month rate
Annual yield annual rate
Kd
Kp
Ke
Current Cost of capital
Can't really use the current cost of capital since accepting any new projects will require issuing new
Preferred stock requiring a rate higher than its current 7.5% yield.
Part b
Use your solutions in Part a to do this part, but if you couldn't complete Part a, assume Kd=4%, Kp=8%, and Ke=13%; =
Knp preferred stock
New cost of capital
Part c
If the capital structure increases more than
new common stock will have to be issued to finance new projects since internally generated RE runs out,
and the required return on common stock will increase as demanded by shareholders.
Part d
Kne common stock
If you could not come up with the Kne common stock returns, do the cost of capital assuming Kd=5%, Knp=9%, and Ke=14%=
New cost of capital
Explanation / Answer
PROBLEM FOR CHAPTERS TEN AND ELEVEN Saint Leo Manufacturing is going to introduce a new product line and to accomplish this it has four projects analyzed in which it wants to invest a total of $100 million. Your job is to find what it will cost to raise this amount of capital and based on the cost of capital determine which of the projects should be accepted by the firm to invest in. PROJECTS A B C D INVESTMENT $30,000,000 $20,000,000 $25,000,000 $25,000,000 EXPECTED RETURN 10.00% 14.00% 11.50% 16.00% The firms capital structure consists of: FMV CAPITAL PERCENTAGE AMOUNT DEBT 30% $15,000,000 PREFERRED STOCK 10% $5,000,000 COMMON STOCK 60% $30,000,000 $50,000,000 Other information about the firm: CORPORATE TAX RATE 35% DEBT CURRENT PRICE $900.00 ANNUAL INTEREST 9.00% CURRENT INTERST PAID SEMIANNUALLY ORIGINAL MATURITY 25 YEARS, BUT NOW 20 YEARS LEFT MATURITY VALUE $1,000.00 FLOTATION COST INSIGNIFICANT MARKET YIELD PROJECTED: UP TO $20 MILLION 9% ABOVE $20 MILLION 12% 3 % additional premium PREFERRED CURRENT PRICE $50.00 LAST DIVIDEND (D0) $5.00 FIXED AT 10% OF PAR FLOTATION COST $2.00 NEXT DIVIDEND (D1) $5.00 COMMON CURRENT PRICE $33.00 LAST DIVIDEND (D0) $1.50 RETAINED EARNINGS $16,000,000 GROWTH RATE (g) 9% FLOTATION COST $3.00 NEXT DIVIDEND (D1) $1.635 NOTE - Once retained earnings is maxed out new common stock will need to be issued. Any preferred stock would be new preferred stock. You may want to review case in chapter 11. REQUIRED: In all of the required parts one part builds on the previous part. If you can't do a part use the set of other numbers to solve the next part. a. What is the current Kd, Kp and Ke assuming no new debt or stock? b. Since any new capital investment will require issuing new perferred stock, what would the the new returns be preferred stock (knp) and the new cost of capital? c. What amount of increase (marginal cost of capital) in capital structure will the firm run out of retained earnings and be forced to issue new common stock? d. If new common stock has to be issued what will the new return required be (Kne) and the new cost of capital? e. What amount of increase (marginal cost of debt) in capital structure will require the firm to borrow at the new interest yield? (Hint look at debt cap for lower rate and % of debt in structure.) f. If new debt is issued the return will change from the current Kd to a new rate (Knd) since the total debt will exceed $15 million. Calculate the new return Knd (hint excel function for effective rate), and the new cost of capital. g. Summarize in a chart what you have calculated in the solutions above into a chart like the one below. Increase levels of capital Cost of Capital Up to $? ?% $? - $? ?% Above $? ?% h. Rank the projects from highest returns to lowest with required amounts of capital. See format below. i. Explain what projects are accepted and why and which are rejected and why? j. Given your answer to i, what then would be the new FMV's of debt and equities? Part a Current price $900.00 Maturity value $1,000.00 Interest payment $45.00 Payment periods 40 Yield rate 5.090% Annual yield 10.18% Kd 6.62% Kp 10.00% Ke 13.95% Current Cost of capital 11.36% Part b Use your solutions in part a to do this part, but if you couldn't complete part a assume Kd=7%, Kp=11%, and Ke=14%. Knp preferred stock 10.42% New cost of capital 11.40% Part c If the capital structure increases more than $26,666,667 Part d Kne common stock 14.45% If you could not come up with the Kne returns do the cost of captial assuming Kd=7%, Knp=12%, and Ke=14%. New cost of capital 12.33% This will consider increased cost of debt in part F Part e Capital structure increase $16,666,667 Part f Knd 8.74% If you could not come up with the Knd returns do the cost of captial assuming Knd=9%, Knp=12%, and Kne=15%. New cost of capital 12.03% Part g Level Cost of Capital Upto 66666667 11.40% 66666667 to 76666667 12.03% Above 76666667 12.33% Part h Projects Return Amounts Cumlative totals D 16.00% $25,000,000 $25,000,000 B 14.00% $20,000,000 $45,000,000 C 11.50% $25,000,000 $70,000,000 A 10.00% $30,000,000 $100,000,000 Part i Projects A and C should be rejected because their return is less than cost of capital. Projects D and B should be accepted because their return is greater than cost of capital. Part j FMV CAPITAL AMOUNT Additions New FMVs Percentage Debt $15,000,000 $13,500,000 $27,150,000 28.12% Preferred stock $5,000,000 $4,500,000 $9,687,500 10.03% Common stock $30,000,000 $27,000,000 $59,700,000 61.84% $50,000,000 $45,000,000 $96,537,500 100.00% Its assumed that equity capital is issued at market price of $33, debt at face value of $1000 and preferred stock at market price of $50
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