Bonanza Brothers Ltd manufactures leather saddles and has the following capital structure which it considers to be optimal under present and forecast conditions:
Proportion Used
Debt 40%
Equity 60%
Total debt and equity 100%
For the coming year, the financial manager Hoss Cartwright expects after-tax earnings of $2.4 million. Bonanza Brothers’ past dividend policy of paying out 60 per cent of earnings will continue. Present commitments from its banker will allow Bonanza Brothers to borrow further amounts of finance according to the following schedule:
Loan Amount and Interest Rate
$0 to $750,000 9%
$750,001 and above 11%
Bonanza Brothers’ taxation rate is 40 per cent. The current market price of its shares is $4.80. Its most recent dividend was $0.46 per share, and the expected growth rate in dividends is a constant 5 per cent per annum. External equity can be sold at a flotation cost of 10 per cent
of the amount raised.
Bonanza Brothers has the following capital investment opportunities for the next year:
Project Cost Internal Rate Return
A $900,000 16% p.a.
B $1,200,000 15%
C $500,000 14%
D $750,000 12%
E $1,000,000 11%
Required:
a. Calculate the break points of total financing associated with each source of capital for Bonanza Brothers.
b. Calculate the costs of equity and debt capital associated with their respective total financing break points.
c. Calculate the weighted average cost of capital (WACC) for each of the ranges of total new financing determined in part a.
d. Which capital projects should Bonanza Brothers accepts for the coming year? Why? Support your answer with the use of a WMCC schedule and IOS graph.