There are $50 million in total assets. Management desires to increase its plant
ID: 2670835 • Letter: T
Question
There are $50 million in total assets. Management desires to increase its plant and equipment during the coming year by $12 million. The company plans to finance 40 percent of the expansion with debt and the remaining 60 percent with equity capital. Bond financing will be at a 9 percent rate and will be sold as its par value. Common stock is currently selling for $50 per share, and flotation costs for new common stock will amount to $5 per share. The expected dividend next year for the company is $2.50. The dividends expected to grow at a 6 percent rate far into the future. The marginal corporate tax rate is 34 percent. Internal funding available from additions to retained earnings is $4,000,000. Please Show work!1. What amount of new common stock must be sold if the existing capital structure is to be maintained?
Ans: $7.2 million / $3.2 million / $4.0 million / $4.8 million
2. Calculate the weighted marginal cost of capital at an investment level of $12 million.
Ans: 11.56% / 5.94% / 9.31% / 7.51%
Explanation / Answer
According to the given information,
Current price of common stock = $50
Flotation cost per share = $5
Expected dividend for the next year (D1) = $2.5
Growth rate (g) = 6%
Tax rate (Tc) = 34%
Weight of debt (Wd) = 40%
Weight of equity (We) = 60%
Cost of debt = 9%
The amount of new common stock that must be sold if the existing capital structure is maintained is
New common stock = 60% ($12,000,000)
= $7,200,000
Therefore, the new amount of common stock that must be sold is $7,200,000
First we have to calculate the new cost of comon equity.
New price of Common stock (P0) = Current price - Flotation cost per share
= $50 - $5
= $45
According to Dividend discount model,
Ke = (D1 / P0) + g
= ($2.5 / $45) + 0.06
= 0.056 + 0.06
= 0.116 or 11.6%
Therefore, the new cost of equity is 11.6%
Pre-tax Cost of debt = 9%
After-tax cost of debt = Pre-tax cost of debt (1 - tax rate)
= 9% (1 - 0.34)
= 5.94%
Calculating the WACC using the below formula:
WACC = (Wd * Rd ) + (We * Re)
= (0.40 * 0.0594 ) + (0.6 * 0.116)
= 0.0236 + 0.0696
= 0.0931 or 9.31%
Therefore, the Weighted average cost of capital is 9.31%
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