Zinger Corporation manufactures industrial type sewing machines. Zinger Corp. re

Question

Zinger Corporation manufactures industrial type sewing machines. Zinger Corp. received a very large order from a few European countries. In order to be able to supply these countries with its products, Zinger will have to expand its facilities. Of the required expansion, Zinger feels it can raise $85 million internally, through retained earnings. The firm's optimum capital structure has been 35% debt, 10% preferred stock and 55% equity. The company will try to maintain this capital structure in financing this expansion plan. Currently Zinger's common stock is traded at a price of $30 per share. Last year's dividend was $1.50 per share. The growth rate is 8%. The company's preferred stock is selling at $45 and has been yielding 6% in the current market. Flotation costs have been estimated at 8% of common stock and 3% of preferred stock. Zinger Corp. has bonds outstanding at 6%, but its investment banker has informed the company that interest rates for bonds of equal risk are currently yielding 5%. Zinger's tax rate is 40%.
a) Compute the cost of Kd, Kp, Ke, Kn.
b) Calculate the initial weighted average cost of capital.
c) How large a capital budget can the firm support with retained earnings financing?

Explanation / Answer

a) Cost of debt

YTM = 5%

T = 40%

We have the following formula for Kd,

Kd = YTM x(1-T)

      = 5% x(1-0.40)

      = 3%

Cost of Preferred stock

Preferred dividend = 100 x6% = 6

Price = 45

Kp = Preferred dividend/ (Price- floatation cost)

      = 6/(45-45x3%)

      = 13.75%

Cost of common stock

Ke = Do x (1+g)/(P- floatation cost)    +g

Ke = 1.50 x(1+0.08)/(30-30x0.08)       +0.08

Ke = 13.87%

Cost of retained earnings

Kn = Do x (1+g)/(P)    +g

Ke = 1.50 x(1+0.08)/(30)       +0.08

Ke = 13.40%

b) Assuming all the equity financing is done through retainer earnings only

WACC = Wd x Kd   + Wp x Kp + We x Kn

            = 0.35 x3   + 0.10 x13.75 + 0.55 x13.40%

            = 9.80%

c) Let’s assume all the equity financing is done through retainer earnings only. The amount of retained earnings is 85 million and it forms 55% of capital structure. Therefore, capital budget would be:

Capital budget = retained earnings/ proportion of retained earnings

                        = 85 million/0.55

                        = 154.545 million

Related Questions

Navigate

• Browse (All)
• Browse Z
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.