Dr. Silver has an opportunity to start a new cosmetic line based on wood pulp ba
ID: 2717691 • Letter: D
Question
Dr. Silver has an opportunity to start a new cosmetic line based on wood pulp based lipstick. He needs to determine the current weighted cost of capital and the revised weighted cost of capital with the new more glamorous product line. Since Jonathan has hired many of his college classmates to work for his company, he decided that you were the best in corporate finance and wants you to evaluate and submit your findings to him (the president). Your entire corporate future with “Uncle Woody’s Pulp Processing and Lipstick Corporation” depends on this project being completed correctly. He offers you the following data: Common Stock 200,000 shares @ $10 per share issued on January 1, 2010 Treasury Rate is 3% and market risk Premium is 6% Stock has a beta 1.5 Retained Earnings $850,000 Current Long Term Debt $1,300,000 @ 8% per year Current Corporate tax Rate is 34% The company stock has increased in value at 12.47% per year. Assume today’s date is January 1, 2014. They now pay a dividend of $2.00. (Hint: Dividend growth is 0%) The cost of the new lipstick operation is $440,000. You have two options to fund this project. First Option - A bank loan offered at 9% per year or Second Option - New stock issued at the current stock price on January 1, 2014. You need to identify the following Define the current weighted cost of capital? Define the weighted cost of capital if a bank loan is obtained for the entire expansion project? Define the weighted cost of capital if the entire operation is funded with new stock issues? Which option would you choose?
Explanation / Answer
As per CAPM
Cost of Equity = risk free rate + market risk premium*beta
Cost of Equity = 3 + 6*1.5
Cost of Equity = 12%
Equity = 200000*10 + 850000 = 2850000
Debt = 1300000
Total = 4150000
Current weighted cost of capital = Weight of Equity*Cost of equity + Weight of Debt*cost of after tax debt
Current weighted cost of capital = 2850000/4150000 * 12 + 1300000/4150000*8*(1-34%)
Current weighted cost of capital = 9.89%
if a bank loan is obtained for the entire expansion project
weighted cost of capital = Current weighted cost of capital *weight + Weight of new debt*cost of after tax debt*100%
weighted cost of capital = 9.89*4150000/(4150000+440000)+ 9*(1-34%) *440000/(4150000+440000)
weighted cost of capital = 9.51%
if the entire operation is funded with new stock issues
cost of new equity = Expected Dividend/Stock Price + growth rate
cost of new equity = 2/(10*1.1247^4) +0
cost of new equity = 12.50%
weighted cost of capital = Current weighted cost of capital *weight + Weight of new equity*cost of new equity
weighted cost of capital = 9.89*4150000/(4150000+440000)+ 12.50 *440000/(4150000+440000)
weighted cost of capital = 10.14%
Decsion : Select First Option - A bank loan offered at 9% per year as it cost of capital is being reduces from current weighted cost of capital
Related Questions
drjack9650@gmail.com
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.