Question

On January 1, 2019, the total assets of the Dexter Company were $270 million. The firm's present capital structure, which follows, is considered to be optimal. Assume that there is no short-term debt.

Long-term debt $135,000,000 Common equity $135,000,000

New bonds will have a 10 percent coupon rate and will be sold at par. Common stock, currently, selling at $60 a share, can be sold to net the company $54 a share. Stockholders' required rate of return is estimated to be 12 percent., consisting of a dividend yield of 4 percent and an expected growth rate of 8 percent. (The next expected dividend is $2.40, so $2.40/$60 = 4%.) Retained earnings are estimated to be $13.50 million. The marginal tax rate is 40 percent. Assuming that all asset expansion (gross expenditures for fixed assets plus related working capital) is included in the capital budget, the dollar amount of the capital budget, ignoring depreciation is $135 million. The marginal tax rate is 40 percent. Assuming that all asset expansion (gross expenditures for fixed assets plus related working capital) is included in the capital budget, the dollar amount of the capital budget, ignoring depreciation is $135 million.

To maintain the present capital structure, how much of the capital budget must Dexter finance by equity?

How much of the new equity funds needed will be generated internally? Externally?

Calculate the cost of each of the equity components

At what level of capital expenditure will there be a break in Dexter’s Marginal Cost of Capital schedule?

Calculate WACC.

Answer 1

Answer :-

a.      Common equity needed: 0.50($135,000,000) = $67,500,000.

b.      Expected internally generated equity (retained earnings) is $13.5 million. External equity needed is as follows:

   New equity needed $67,500,000    Retained earnings    13,500,000

       External equity needed    $54,000,000

c.      Cost of equity:

k_s    = Cost of retained earnings

= Dividend yield + Growth rate = 12% = 4% + 8% = 12%.

= /P₀ + g = $2.40/$60 + 0.08 = 0.04 + 0.12 = 12.0%.

k_e   = Cost of new equity

= /NP + g = $2.40/$54.00 + 0.08 = 0.044 + 0.08 = 0.124 = 12.4%.