Ross, Inc. has a target capital structure that calls for 40% debt and 60% common equity and no preferred stocks. The firm has bonds outstanding with 20 years remaining to maturity, 8% coupon paid annually, a par value of $1000, and selling today for $829.73 with no flotation cost. Ross expects to have retained earnings of $15,000 over the next year. Ross' common stock currently sells for $28 per share, but the firm has to pay $6 per share as flotation on sale of the new issues of common stock. The firm recently paid a dividend of $2 (Do) per share on its common stock, and investors expect the dividend to grow indefinitely at a constant rate of 10 percent per year. The risk-free rate is 5%, market expected return is 15%, and the firm's beta risk is 1.2. Ross uses CAPM in estimating its cost of retained earnings. The tax rate is 40%.
a) What is the firm's cost of debt (ra)?
b) What is the firm's cost of retained earnings (rs)?
c) What is the firm's cost of newly issued common stock (re)?
d) What is the amount of the firm's retained earnings break point?
e) What is the value of WACC1 (using debt and retained earnings)
f) What is the value of WACC2 (using debt and common stock)?
g) Draw the Marginal Cost of Capital schedule and explain what it means.
h) If project A has IRRA=11% and requires $40,000 capital and project B has IRRB=14%, and requires $20,000, which project(s) would you choose? What will be your optimal cost of capital and your optimal amount of financing required? Show these projects on the graph in part f.