Question 6 Star Products Company is a growing manufacturer of automobile accesso

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Question 6

Star Products Company is a growing manufacturer of automobile accessories whose stock is actively traded on the over-the-counter (OTC) market. During 2012, the Dallas-based company experienced sharp increases in both sales and earnings. Because of this recent growth, Melissa Jen, the company’s treasurer, wants to make sure that available funds are being used to their fullest. Management policy is to maintain the current capital structure proportions of 30% Long-term debt, 10% pre— ferred stock) and 60% common stock equity for at least the next 3 years. The firm is in the 40% tax bracket.

Star’s division and product managers have presented several competing investment opportunities to Jen. However because funds are limited, choices of which projects to accept must be made. The investment opportunities schedule (IOS)

To estimate the firm’s weighted average cost of capital (WACC), Jen contacted a leading investment banking firm, which provided the financing cost data shown in the following.

Long-term debt: The firm can raise $450,000 of additional debt by selling 15-year, $1,000-par-value, 9% coupon interest rate bonds that pay annual interest. It expects to net $960 per bond after flotation costs. Any debt in excess of $450,000 will have a before-tax cost, rd, of 13%.

Preferred stock, regardless of the amount sold, can be issued with a $70 par value and a 14% annual dividend rate and will net $65 per share after flotation costs.  

Common stock equity: The firm expects dividends and earnings per share to be $0.96 and $3.20, respectively, in 2013 and to continue to grow at a constant rate of 11 % per year. The firm’s stock currently sells for $12 per share. Star expects to have $1,500,000 of retained earnings available in the coming year. Once the retained earnings have been exhausted, the firm can raise additional funds by selling new common stock, netting $9 per share after underpricing and flotation costs.

a. Calculate the cost of each source of financing, as specified:

(1) Long-term debt, first $450,000.

1.         The before tax cost of debit is ---

2.         The after tax cost of debit will be---

(2) Long-term debt, greater than $450,000.

The after tax cost of debit---

(3) Preferred stock, all amounts.

            The cost of preferred stock will be --

(4) Common stock equity, first $1,500,000.

The cost of common stock equity will be ----

(5) Common stock equity, greater than $1,500,000.

The cost of common stock equity will be ---

b. calculate Star’s weight average cost of capital (WACC) for each of the following situation;

(1) long-time debt less than 450,001 and common stock equity less than $1,500,001

the WACC will be

long time debt greater than 450,000 and common stock equity less than 1500,001

the Wacc will be

long time debt greater than 450,000 and common stock equity less than 1500,000

the Wacc will be

The breakeven is

The maximum amount offinancing is

Explanation / Answer

Part A)

1) Long-term debt, first $450,000

The cost of debt can be estimated with the use of Rate function/formula of EXCEL/Financial Calculators. The function/formula for calculating Rate is Rate(Nper,PMT,-PV,FV) where Nper = Period, PMT = Interest Amount, PV = Current Price of Bond and FV = Face Value of Bond

_____________

Here, Nper = 15, PMT = $1,000*9% = $90, PV = 960 and FV = $1,000

Using these values in the above formula/function for Rate, we get,

Before-Tax Cost of Debt = Rate(15,90,-960,1000) = 9.51%

After-Tax Cost of Debt = Before-Tax Cost of Debt*(1-Tax Rate) = 9.51*(1-40%) = 5.71%

____________

2) Long-term debt, greater than $450,000

Since, we have been provided that the cost of debt for any amount greater than $450,000 would be 13%, we can directly calculate the after-tax cost of debt.

After-Tax Cost of Debt = Before-Tax Cost of Debt*(1-Tax Rate) = 13*(1-40%) = 7.80%

____________

3) Preferred stock, all amounts

The cost of preferred stock can be calculated with the use of following formula:

Cost of Preferred Stock = Annual Dividend/Current Stock Price*100

_____________

Using the values provided in the question, we get,

Cost of Preferred Stock = (14%*70)/65*100 = 15.08%

____________

4) Common stock equity, first $1,500,000

The cost of common equity can be calculated with the use of following formula:

Cost of Common Equity = D1/P0 + Growth Rate where D1 = Expected Dividend and P0 = Current Stock Price

_____________

Using the values provided in the question, we get,

Cost of Common Equity = .96/12 + 11% = 19%

____________

5) Common stock equity, greater than $1,500,000

With additional equity, the current share price would be $9. We will use this price for calculating the cost of common equity.

_____________

Cost of Common Equity = .96/9 + 11% = 21.67%

___________

Part B)

The calculation of WACC have been shown in the tables below:

1) Long-time debt less than 450,001 and common stock equity less than $1,500,001

___________

2) Long time debt greater than 450,000 and common stock equity less than $1,500,001

___________

3) Long time debt greater than 450,000 and common stock equity greater than 1,500,001

___________

Part C)

The formula for calculating break even point is:

Break Even Point = Amount of Equity (Retained Earnings Available)/Weight of Equity

___________

Using the values provided in the question, we get,

Break Even Point = 1,500,000/60% = $2,500,000

___________

Part D)

The maximum amount of financing is the break even level for debt, the formula for which is:

Break Even Point = Amount of Debt/Weight of Debt

___________

Maximum Amount = 450,000/30% = $1,500,000

Type of Financing Weight in the Capital Structure (A) Cost (B) Weighted Cost of Capital (A*B) Debt 30.00% 5.71% 1.71% Preferred Stock 10.00% 15.08% 1.51% Equity 60.00% 19.00% 11.40% WACC 14.62%

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