The Washington & Willis Brassiere Company has determined that their optimal capi

Question

The Washington & Willis Brassiere Company has determined that their optimal capital structure is

                                    Debt    50%

                                    Equity 50%

                                                100%

They know from their prior analysis that their total capital budgeting expenditures for next year is $45,800,000, thus W&W must raise $22,900,000 of new debt plus another $22,900,000 of equity. $22,900,000 of new debt may be raised at a before-tax cost of 8 percent. The firm will have retained earnings of $10,000,000 available for capital projects next year, thus an additional $12,900,000 must be raised in a new issue of stock. The current price of the stock is $40 per share and the last dividend was (Do = $2.00). The W&W Company has a tax rate of 40 percent and anticipates a return of (ROE)=13.0 percent on new equity investments. The firms’ earnings per share is $4.00 (E0= $4.00) and the growth implied by the retention ratio and return on new equity invested capital is expected to continue for the future, g=(1-p)*ROE. You also find that the 10-year US Treasury rate is 4 percent, the stock has a beta () of 1.565 and the market risk premium is 5.0%. New common stock may be issued with a 7% flotation cost. Please draw the weighted average cost of capital (WACC) marginal cost curve for capital available for W&W Company new capital investment. (Hint: Plot the weighted average cost of capital showing a break point on the M.C. curve when the firm exhausts its $10,000,000 of retained earnings and must begin issuing new common stock with a flotation cost of 7%.)

Estimate the cost for the $22,900,000 of new debt.

                        Cost of new debt: rd =

Using both the CAPM and DCF models, estimate the cost of the $10,000,000 of retained earnings and then using the DCF approach estimate the cost of new issue common stock with a flotation cost of 7%. Note that the new stock will be issued at the current market price of $40 per share however, W&W will realize only $37.20 per share because of the flotation cost of the new issue stock

            Break point in WACC caused by exhausting retained earnings =

            Cost of Retained Earnings:

            CAPM:

            DCF Model:

            Where g = (1-p) ROE =

Explanation / Answer

Cost of new debt: rd = before-tax cost * (1- tax rate) = 8*(1-0.4) = 4.80%

Cost of Retained Earnings:

CAPM = Risk free return + Beta * Market risk premium = 4+1.565*5 = 11.825%

DCF Model:

In g = (1-p) ROE , p is defined.

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