1. Tara BethTM has a capital structure consisting of 60% debt and 40% common stock. The company's Chief Financial Officer has obtained the following information:
- The before-tax YTM on the company's bonds is 8.25%.
- Kramerica will pay a $2.95 dividend on its common stock and the dividend is expected to grow at a constant rate of 6% a year. The common stock currently sells for $50 a share.
- Assume the firm will be able to use retained earnings to fund the equity portion of its capital budget.
- The company's tax rate is 40%.
a. What is Kramerica's WACC?
b. Two independent projects are available for Kramerica to invest in: Project A has an IRR of 10%, while Project B's has an IRR of 12.5%. These two projects are equally risky and are of average risk. Which project(s) should Kramerica accept?
2. Abbott Printing plans to issue a $1,000 par value, 15-year bond with a 7.20% annual coupon, paid semiannually. The company applies an average tax rate of 40% for cost of capital decision-making purposes but Congress is considering a change in the corporate tax rate. This change would bring the firm's average tax rate down to 30%. By how much would the after-tax component cost of debt used to calculate the WACC change if the new tax rate is adopted?
3. Davola Inc. has the following financial information:
- Debt: The firm issued 1,000, 20 year bonds five years ago which were sold at a par value of $1,000. The bonds carry a coupon rate of 8.1%.
- PreferredStock: Pays a 9.25% preferred dividend with a par of $100 and is currently selling for $86.
- Equity:Davola's common stock currently sells for $32 and grows at a constant rate of 5%. Davola just paid a $2.25 dividend to their shareholders.
- Davola's business plan for next year projects net income of $340,000, half of which will be retained.
- The company applies an average tax rate of 35% for cost of capital decision-making purposes.
- Dovola Inc. pays flotation costs of 10% on all new stock issues.
- Dovola's capital structure is 40% debt, 15% preferred stock and 45% common equity.
a. Compute the capital component costs for each of the capital components (debt, preferred stock and equity using retained earnings). Ignore flotation costs for debt and preferred stock.
b. Calculate the WACC before the break in retained earnings.
c. Calculate Davola's break point in retained earnings.
d. Calculate the WACC after the break in retained earnings. In other words, calculate the WACC given the point that the firm will have to issue new stock to fund the equity portion of its capital budget.