Problem
Peritas Inc. is offering $6 for its next dividend, its common stock price is $80 and its average annual growth rate is estimated at 10% for the future.
Additional information is provided as follows:
The cost of issuing and purchasing new common stock is 12% of the stock price
The yield to maturity of the debt is 14% and the issue and underwriting costs are 6% of the face value of the bond;
The preferred shares have a market yield of 15% and the brokerage fees are 10% of their market value of $40;
The corporate income tax rate is 40%;
Peritas' optimal financing structure is as follows: debt (bonds) represents 30% of total financing, preferred shares 10% and net worth 60%;
The firm plans to generate $100 million in net income in 1992. This amount will be allocated as follows:
40 million will be paid in dividends;
60 million will be reinvested in the firm.
You are asked to:
1. Calculate the marginal cost of capital to the extent that the reinvested earnings in 1992 are sufficient on the net worth side to finance the firm's new projects; also calculate in a first step the total amount of new capital that can be raised on the basis of the reinvested earnings for the year as well as determine its allocation;
2. Calculate the firm's marginal cost of capital for the portion of new capital that exceeds that found above. Indeed, the managers of Peritas Inc. have the ambition to make very large investments in 1992;