Rolodex, Inc. is in the process of determining its capital budget for the next fiscal year. The firm’s current capital structure, which it considers to be optimal, is contained in the following balance sheet:
Rolodex, Inc. Balance Sheet (in millions of $)
Current assets $110 Accounts payable $30
Fixed assets 260 Other current liabilities 20
Total assets $370 Long-term debt 128
. Preferred stock 32
. Common stock (20 million shares) 50
. Retained earnings 110
. Total liabilities & equity $370
Discussions between the firm’s financial officers and the firm’s investment and commercial bankers yielded the following information:
Debt: Rolodex can borrow $40 million from its bank at a pre-tax cost of 13%. After using up its bank loans, Rolodex can borrow $80 million by issuing bonds at a net price of $687 per bond. The bonds would carry a 10% coupon rate (paying its interest twice a year) and mature in 20 years. Additional bond can be issued at a pre-tax cost of 16%.
Preferred: Preferred stock can be issued at a pre-tax cost of 16.5%.
Equity: Rolodex can generate $140 million in net income and pay $2 per share in dividends. The $2 per share dividend (D1) represents a growth of 5.5% over the previous year’s dividend. This growth rate is expected to continue for the foreseeable future. The firm’s stock is currently trading at $16 per share. Rolodex can raise external equity by selling common stock at a net price of $15 per share.
Tax: Rolodex’s marginal tax rate is 40%.
The following are the available investment opportunities (all projects are non-divisible):
Project Required Investment IRR
A $24,000,000 13.0%
B $100,000,000 15.2%
C $16,000,000 10.9%
D $80,000,000 14.2%
E $130,000,000 16.0%
F $140,000,000 17.0%
a. Plot Rolodex’s marginal cost of capital schedule. Show your work.
b. Plot Rolodex’s investment opportunity schedule.
c. Determine Rolodex’s optimal capital budget and its marginal cost of capital.