The Mason Corporation\'s present capital structure, which is also its target cap

Question

The Mason Corporation's present capital structure, which is also its target capital structure, calls for 50 percent debt and 50 percent common equity. The firm has only one potential project, an expansion program with a 10.2 percent IRR and is completely divisible-that is, Mason can invest any amount up to $20 million. The firm f earnings next year. It can raise up to $5 million in new debt at a before-tax cost of 8 on, W and the firm can sell any amount of new common stock desired at a constant cost of 15 perce rate is 40 percent. million will have a cost of 10 percent. The cost of retained earnings is 12 percent, nt. The firm's marginal tax a. What is the firm's optimal capital budget?

Explanation / Answer

In this case, optimal capital budget is the level of the budget at which the cost of capital is equal to IRR of the project.

With 3m in equity and 3m in debt, for a total capital of $6 million,

WACC = wd x kd x (1 - tax) + we x ke = 50% x 8% x (1 - 40%) + 50% x 12% = 8.40%

where, wd - weight of debt = 50%, kd - cost of debt = 8%, tax = 40%, we - weight of equity = 50%, ke - cost of equity = 12%

With 3m in earnings, 2m in new equity and debt of 5m, WACC for total capital of 10m

WACC = 0.3 x 12% + 0.2 x 15% + 0.5 x 8% x (1 - 40%) = 9.00%

Similarly, calculate WACC for total capital of 20m

WACC = 3/20 x 12% + 7/20 x 15% + (5/20 x 8% + 5/20 x 10%) x (1 - 40%) = 9.75%

Hence, the firm's optimal capital buget is full $20 million at which is WACC < IRR.

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