St-2 WACC Lancaster Engineering Inc. (LEI) has the following capital structure,

Question

St-2 WACC Lancaster Engineering Inc. (LEI) has the following capital structure, which it considers to be optimal: Debt Preferred stock Common equity 25% 15 60 100% LEI's expected net income this year is $34,285.72; its established dividend payout ratio is 30%; its federal-plus-state tax rate is 40%; and investors expect future earnings and dividends to grow at a constant rate of 9%. LEI paid a dividend of $3.60 per share last year, and its stock currently sells for $54.00 per share. LEI can obtain new capital in the following ways New preferred stock with a dividend of $11.00 can be sold to the public at a price of $95.00 per share Debt can be sold at an interest rate of 12% a. Determine the cost of each capital component. b. Calculate the WACC. c. LEI has the following investment opportunities that are average-risk projects: Project Rate of Return 17.4% 16.0 14.2 13.2 12.0 Cost at 0 $10,000 20,000 10,000 20,000 10,000 Which projects should LEI accept? Why? Assume that LEI does not want to issue any nevw common stock

Explanation / Answer

Here we have

Net income=$34285.72

Dividend payout ratio=30%

federal tax rate=40%

Growth=9%

previous year dividend=$3.60

price of stock=$54

a) We know that cost of equity is given the below formulae

ke=(D1/Po)+g, where ke= cost of equity D1=expected dividends Po=price of stock g=growth rate

D1=Do(1+g) where Do is current dividends

D1=3.6(1+0.09)=3.94

ke=(3.94/54)+0.09=0.162~16.2%

cost of prefered stock is given by the below formulae

kp=Dps/P, where kps=cost of prefered stock Dps=prefered dividends p=market price of prefered

here we have

Dps=11 and P=95

kps=11/95=0.1157~11.57%

cost of debt we are given interest rate=12%

federal tax rate =40%

after tax cost of debt(kd) =12%(1-0.4)=12*0.6=7.2%

b) WACC= we*ke+wd*kd+wp*kp

we=60% wd=25% wp=15%

WACC=we*ke+wd*kd+wp*kp=0.6*(0.162)+025*(0.1157)+0.15*(0.072)=0.1369~13.69%

c) LEI should accept projects that have rate of return more than the Weighted average cost of capital(WACC)

and here projects A, B, C have rate of return more than WACC=13.69%

hence LEI should accept Projects A,B and C

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