Question

A company approached you as it is seeking your assistance in order to raise a given level of cash to finance a project that has a useful life of 10 years. They would like to expand their business and is seeking to raise $100 M which will be just about enough cash for the complete the expansion. The company is in a marginal tax rate bracket of 34%.From their own history and based on previous analysis they would like to raise the cash using the following sources and amounts:

1.New common stock of $28 M with the latest closing price of $32.00 and a last paid dividend of $1.75, an annualized dollar amount. The company is anticipating a growth rate of 10% and is expected to incur a flotation cost her is 2% of the closing market price. In other words, you need to value the stock down by 2%

2. Retained Earnings of $12 M. In this case you will be required to value the retained earnings based on an non-discounted market price of the common stock.

3. Your job is t inform the company who will undertake the expansion if and only if the WACC meets their bench mark rate of 7.25% or lower. Make your recommendation to the company.

Answer 1

Cost of Equity Stock (K_e) = (Dividend in Year 1 / Current Market Price net of floatation cost) + Growth rate i.e. K_e = D₁ / P₀ + g.

= 1.75*1.1 / (32 - 2%) + 0.1

i.e. K_e = 16.14 %

Cost of retained earnings (K_r) = K_e at non-discounted market price of the common stock.

i.e. = 1.75 * 1.1 / 32 + 0.1 = 16.02 %

WACC = W_eK_e + W_rK_r = (28 * 16.14 + 12 * 16.02) / 40 = 16.104%

Recommendation : Since, WACC is above the bench mark rate of 7.25%, company should not undertake the expansion.