You develop the following information. Your firm has a target capital structure of 70% common equity, 5% preferred stock and 25% debt. The firm’s tax rate is 25%.
The firm can issue up to $200,000 worth of debt at a before-tax cost of 9%. Then it will cost the firm 11% before-tax on debt up to $400,000. After that point, the before-tax cost of debt will be 13%.
The firm’s preferred stock carries an annual dividend of $2 per share. The issue price of the preferred would be $25 with 1.5% of the issue price charged as flotation costs.
The firm expects to have $950,000 in earnings and have a dividend payout ratio of 65%. The firm bases its cost of retained earnings on the CAPM approach. For this purpose, you determine the growth rate of the market will be 5% and the market dividend yield is 2%. The risk-free rate is 3%. The firm’s beta is 1.05.
The firm can issue new common stock with a $0.50 dividend, price of $20 per share, flotation costs of 1.75% of issue price and growth rate expected of 6%. This holds for up to $630,000 in equity after which it will cost 10% for new common stock.
>Determine the marginal cost of capital schedule.
>Determine which projects you would accept and what the optimal capital budget would be by combining the investment opportunity schedule (information below) and marginal cost of capital schedule.
Project Initial Cost IRR
A $375,000 8.5%
B $300,000 11%
C $175,000 10%
D $100,000 7.5%
E $200,000 6%
Show detailed work