A firm finances with both bonds and common equity, but does not wish to issue an

Question

A firm finances with both bonds and common equity, but does not wish to issue any new common stock during the coming year due to sub-optimal market conditions. It has committed to maintaining the dividend at the projected level. Given these constraints and the tollowing intormation, what percentage of the capital budget must be financed with debt? Projected capital budget Common shares outstanding Nominal cost of debt State +federal tax rate Projected dividend per share Projected EPS $800,000 500,000 11.75% 25% $2.75 $4.00

Explanation / Answer

We first need to calculate the amount that is left after paying out dividends (Retained Earnings)

Retained earnings per share = $4 - $2.75 = $1.25

Total retained Earnings = $1.25 * 500,000 = $625,000

So this retained earnings can be used in project. The deficit would be financed from debt = $800,000 - $625,000 = $175,000

% of debt financing in capital budget = $175,000/$800,000 = 21.875%

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