Timel Company is in the process of determining its capital budget for the coming fiscal year. Timel Company’s balance sheet reflects five sources of long-term funds. The current outstanding amounts from these five sources are shown below and represent the company’s historical sources of funds fairly accurately.
Source of Funds.....$ Amount (in Millions).....%
Mortgage bonds...................135........................ 15
Debenture bonds.................225..........................25
Preferred stock....................90...........................10
Common equity.................450..........................50
Total...................................900............................100
Timel will raise the funds necessary to support the selected capital investment projects so as to maintain its historical distribution among the various sources of long-term funds. Thus, 15% will be obtained from additional mortgage bonds on new plant, 25% from debentures (a generic type of bonds), 10% from preferred stock, and 50% from some common equity source. Timel’s policy is to reinvest the funds from each year’s earnings in new projects. Timel issues new common stock only after all funds provided from retained earnings have been exhausted.
Management estimates that its net income after taxes for the coming year will be $4.50 per common share (for 15 million shares). The dividend payout ratio will be 40% of earnings to common shareholders, the same ratio as the prior 4 years. The earnings retained will be used as needed to support the capital market.
Source of Funds....Par Value ($)....Characteristics........................Issue Price ($)
Mortgage bonds........1,000............30 year, 7½%, annual payment..........980.00
Debentures..............1,000............25 year, 8%, semi-annual payment....1,100.00
Preferred stock..........100......................................7%.................................99.25
Common stock............10............................................................................67.50
The estimated interest rates on the debt instruments and the dividend rate on the preferred stock are based upon the rates being experienced in the market by firms that are of the same size and quality as Timel. The investment banker estimated Timel’s annual growth rate to be 10%. In addition, the bank is charging Timel a floatation cost of 7% for its common and preferred equities offering but nothing for its debt offerings. Timel is subject to a 35% income tax rate.
a. What is the cost for each of the five sources of capital (i.e. mortgage bonds, debenture bonds, preferred stock, retained earnings, and common stock) for Timel Company?
b. What is the break point associated with Timel’s MCC schedule?
c. What is the average cost of capital for each interval of Timel’s MCC schedule?