Question

Rolodex Inc. is in the process of determining its capital budget for the next fiscal year. The firm’s current capital structure, which it considers to be optimal, is contained in the following balance sheet:

Note: For this problem, use the book value of the items to get the capital structure. However, you normally want to use the market values. Long-term debt is the only debt capital structure account. Add common stock, capital in excess of par, and RE to get common equity.

Rolodex Inc. Balance Sheet (in Millions of Dollars)
	Current assets		$	105			Accounts payable		$	35
	Fixed assets			255			Other current liabilities			25
	Total assets		$	360			Long-term debt			90
							Preferred stock			60
							Common stock (15 million shares at par)			15
							Contributed capital in excess of par			30
							Retained earnings			105
							Total liabilities and equity		$	360

Discussions between the firm’s financial officers and the firm’s investment and commercial bankers have yielded the following information:

• Rolodex can borrow $30 million from its bank at a pretax cost of 11 percent.
• Rolodex can borrow $25 million by issuing bonds at a net price of $875 per bond. The bonds would carry a 13 percent coupon rate and mature in 15 years.
• Additional debt can be issued at a 17 percent pretax cost
• Preferred stock can be issued at a pretax cost of 18 percent.
• Rolodex expects to generate $120 million in net income and pay $2.15 per share in dividends.

Hint: RE = Net income - total common dividends.There are 15m shares shown as outstanding in the balance sheet.

• The $2.15 per share dividend (D₁) represents a growth of 5.5 percent over the previous year’s dividend. This growth rate is expected to continue for the foreseeable future. The firm’s stock currently is trading at $16.5 per share.
• Rolodex can raise external equity by selling common stock at a net price of $14.5 per share.
• Rolodex’s marginal tax rate is 40 percent.

Round your answers to two decimal places. 10.12% would be entered as 10.12

Compute Rolodex’s marginal cost of capital schedule.

	Weighted marginal cost of capital
First increment:	%
Second increment:	%
Third increment:	%
Additional funds:	%

Answer 1

1]	The first step is the calculation of the cost of capital of the
	various sources of capital.
a]	Cost of debt [after tax]:
	After tax cost of bank loan = 11%*(1-40%) =	6.60%
	Before tax cost of bonds = YTM
	YTM using an online calculator = 15.15%
	After tax cost of bonds = 15.15%*(1-40%) =	9.09%
	After tax cost of additional debt = 17%*(1-40%) =	10.20%
	Cost of preferred stock [given]	18.00%
	Cost of retained earnings = 2.15/16.5+0.055 =	18.53%
	Cost of new equity = 2.15/14.5+0.055 =	20.33%
b]	Book value weights are:	BV in millions	Weight
	Debt	$                    90	30.00%
	Preferred stock	$                    60	20.00%
	Equity	$ 150	50.00%
	Total	$ 300
c]	Retained earnings available = 120-15*2.15 =	$              87.75	million
	RE break point = 87.75/50% =	$ 175.50	million
	Preferred stock = 175.50*20% =	$              35.10	million
	Debt = 175.50*30% =	$              52.65	million
	So break points are:
	1] Debt break point [bank loan] = 30/30% =	$ 100.00	million
	Components:
	Debt at 6.60% for $30 million
	Preferred stock at 18% for $20 million
	Equity [Retained earnings] at 18.53% for $50 million
	WACC = 6.60%*30%+18%*20%+18.53%*50% =	14.85%
	2] RE break point = 87.75/50% =	$           175.50	million
	WACC = 9.09%*30%+18%*20%+18.53%*50% =	15.59%
	3] Debt [bond] break point for $25 million = 100+25/30% =	$           183.33	million
	WACC = 9.09%*30%+18%*20%+20.33%*50% =	16.49%
	4] Additional debt:
	WACC = 10.20%*30%+18%*20%+20.33%*50% =	16.83%
	ANSWERS:	$ million	Marginal WACC
	First increment	$ 100.00	14.85%
	Second increment	$              75.50	15.59%
	Third increment	$                7.83	16.49%
	Additional funds		16.83%