Longstreet Communications, Inc. (LCI), has the following capital structure, whic

Question

Longstreet Communications, Inc. (LCI), has the following capital structure, which it considers to be optimal:

                                    Debt                               25%

                                    Preferred stock               15

                                    Common stock               60

                                                                        100%

      LCI’s net income expected this year is $17,142.86; its established dividend payout ratio is 30%; its tax rate is 40%; and investors expect earnings and dividends to grow at a constant rate of 9% in the future. LCI paid a dividend of $3.60 per share last year (D0), and it’s stock currently sells at a price of $60 per share. Treasury bonds yield 11%; an average stock has a 14% expected rate of return; and LCI’s beta is 1.51. These terms would apply to new security offerings:

      Common:       New common stock would have a flotation cost of 10%.

      Preferred:      new preferred would be sold to the public at a price of $100 per share, with a dividend of $11. Flotation costs of $5 per share would be incurred.

      Debt:               Debt could be sold at an interest rate of 12%

a.   Find the component costs of debt, preferred stock, retained earnings, and new common stock.

b.   How much new capital can be raised before LCI must sell new equity? (In other words, find the retained earnings break point.)

      c.   What is the WACC when LCI meets its equity requirement with retained earnings? With new common stock?

      d.   Construct a graph showing LCI’s MCC schedule.

Explanation / Answer

Ans:

Cost of debt will be = interest rate of Debt*(1-tax rate) = 12%*(1-40%) = 7.2%

Cost of retain earnings = CAPM Model explain= Risk Free rate+ (Market return- Risk Free Rate)* Beta = 11%+(14%-11%)*1.51 = 15.53%

Cost for Preference Share = Amount of preference Dividend/(Par Value of Preference share capital-Floating Cost)

11/(100-5)= 11.57%

Cost for new stock =[ D1/(Stock Price*(1-Floating Rate)]+growth rate of the dividend

LCI’s net income expected this year is $17,142.86; its established dividend payout ratio is 30%

Dividend= 17142.86*30%= $5142.85

D1=D0*(1+g)

g=9%, D0=$3.6, stock price=$60

D1=3.6*1.09=3.92

As per the formula

Cost of new stock= [3.92/(60*(1-10%)]+0.09=16.26%

b) Retained earnings break point = Retained Earnings/ Fraction of Equity

Retained earnings = (Net Income- Dividend Paid)=(17142.86-5142.85)= $12000/60%= $20000

C) WACC= Cost of Debt* Weight of Debt+ Cost of Equity*Weight of Equity+ Cost of Preference share*Weight of preference share

WACC=7.2%*25%+15.53%*60%+11.57%*15%= 12.85%

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