The following information pertains to the capital program of a firm: Target capi
ID: 2708639 • Letter: T
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
If the combined federal and state corporate tax rate is 40% and retained earnings of $1 million are expected to be available, which project(s) should the company undertake?
Projects A and B
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