The following information pertains to the capital program of a firm: Target capi

Question

The following information pertains to the capital program of a firm: Target capital structure: 30% debt, 20% preferred stock, 50% equity. Unadjusted component costs of capital kd = 10% kp = 12% ke = 14% Flotation Costs, Taxes, and Retained Earnings Flotation costs are 8% on common and preferred stock and zero on debt The total effective tax rate (federal and state) is 40% Retained earnings of $1,250,000 are expected next year. Investment Opportunities Project Investment IRR A $1 million 13.0% B $2 million 12.5% C $3 million 11.8% D $1 million 11.0% a. Adjust the component costs of capital for taxes and flotation costs, and calculate the WACC before and after the first break. - 50 pts b. Calculate the location of the break point. -50 pts c. Sketch the MCC and the IOS on the same graph. What is the cost of capital for the year? Why? - 50 pts d. Which projects should the firm undertake? Why? - 50 pts

Explanation / Answer

1. Cost of debt:

- The calculation of cost of debt given in question (10%(1-.40) = 6.00%) is not correct.

- Interest on Debt is an item of expense. It has, therefore, paid from the pre-tax profits.

- Hence, the rate of interest itself is the cost of debt ,ie, 10% in the present case.


2. Cost of Preferred Stock:

- The calculation of cost of preferred stock [12%/(1-.08) = 13.04%] is also not correct.

- Dividend on preferred stock is paid from after-tax profits. Hence, the rate has to be brought to pretax level as under:

Dividend on Preferred stock(100/60) = 12(1.66667) = 20%

3.Cost of equity:

- Dividend on equity is paid from 'after-tax' profits. Therefore, the rate has to be brought to 'pre-tax' level:

Dividend Rate(100/60) = 14(1.66667) =23.33%

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