On January 1 the total market value of DOS Company was $50 million. During the year, the company plans to raise and invest $10 million in new assets. The firm's present market value, optimal capital structure is $10 million debt and $40 million equity. Up to $1 million in new bonds can be sold for $975 each if the maturity is 10 years, the face value is $1000 and the annually paid coupon rate is 11%. Selling any bonds beyond that point will raise only $950 each. Assume that there is no short-term debt. The common stock is currently selling at $45 per share and can be sold to net the company $43 a share after flotation costs, The beta of the firm is 1.5 and the risk-free rate is 8% while the return on the market is 12%. The dividend is $3.38 to be paid next year, and the firm has an annual expected growth rate of 7.5% which is expected to be continuous for the foreseeable future. The bond yields plus risk premium approach assumes that stock earn at least 4% more than the initial rate on debt issued by the company. Retained earnings are projected to be $5 million and the marginal tax rate is 40%.
A. How much of the capital budget must be financed by common equity to maintain the optimal capital structure? How much of the new funds are generated by new debt? New stock?
B. Calculate the two costs of Debt?