Problem:
Shine and Glow Company (S&G) uses only debt and equity. It can borrow unlimited amounts at an interest rate of 12 percent so long as it finances at its target capital structure, which calls for 45 percent debt and 55 percent common equity. Its last dividend was $2.40, its expected constant growth rate is 5 percent, and its stock sells for $24. S&G's tax rate is 40 percent. Four projects are available: Project A has a cost of $240 million and a rate of return of 13 percent, Project B has a cost of $125 million and a rate of return of 12 percent, Project C has a cost of $200 million and a rate of return of 11 percent, and Project D has a cost of $150 million and a rate of return of 10 percent. All of the company's potential projects are independent and equally risky.
What is S&G's cost of common equity?
What is S&G's WACC? In other words, what WACC cost rate should it use to evaluate capital budgeting projects (these four projects plus any others that might arise during the year, provided the WACC remains as it is currently)?
What is S&G's optimal capital budget (in millions)?
Assume now that all four projects are independent; however, Project A has been judged a very risky project, while Projects C and D have been judged low-risk projects. Project B remains an average-risk project. If S&G adjusts its WACC by 2 percentage points up or down to account for risk what is its optimal capital budget (in millions) now?