Question

Max Laboratories Inc. has been operating for over thirty years producing medications and food for pets and farm animals. Due to new growth opportunities they are interested in your expert opinion on a series of issues described below. The firm has a target capital structure of 40 percent debt and 60 percent common equity, which the CFO considers to be the optimal capital structure and plans to maintain it in the future. Next year the firm forecasts Earnings per share (EPS) of $15. Max Labs has One million common shares outstanding. The firm has a line of credit at the local bank at the following interest rates: Can borrow up to $6,000,000 at an 8% interest rate; the rate goes to 10% for amounts above $6,000,000. The firm’s interest subsidy tax rate is 25 percent. The firm plans to retain 70% of the forecasted Net income; the remaining 30% of the estimated profits will be paid as dividends to common shareholders next year. Currently common shares sell for $110 and the expected earnings growth is 9%. The floatation costs to raise new common equity capital, equal 7% of the share price. 1. Estimate the weighted average costs of capital for Max Laboratories: A) After-tax cost of debt. B) Cost of equity. C) Cost of new equity. 2. Calculate all of the Marginal cost of capital break points. Show the amount of total capital and how much would be raised from Common Equity and Debt at each point. A) Before the firm has to raise new equity. B) With the cost of new common equity but before the firm has to borrow at the higher interest rate. C) With New cost of equity and at the most expensive cost of debt. 3. Calculate the Weighted average cost of capital at all the break points found on Question 2 above. A) Before the firm has to raise new equity. B) With the cost of new common equity but before the firm has to borrow at the higher interest rate. C) With New cost of equity and at the most expensive cost of debt.

Answer 1

1. Estimate the weighted average costs of capital for Max Laboratories: A) After-tax cost of debt.

For debt up to: $6,000,000 at an 8% interest rate = Rd x (1 - T) = 8% x (1 - 25%) = 6%

for amounts above $6,000,000 = 10% x (1 - 25%) = 7.5%

B) Cost of equity = D1 / P + g = 15 x 30% / 110 + 9% = 13.09%

C) Cost of new equity = D1 / Price net of flotation cost + g = 15 x 30% / [(110 x (1 - 7%)]+ 9% = 13.40%

2. Calculate all of the Marginal cost of capital break points. Show the amount of total capital and how much would be raised from Common Equity and Debt at each point.

A) Before the firm has to raise new equity.

Equity through retained earnings = EPS x Nos. of shares outstanding x Retention ratio = 15 x 1,000,000 x 70% = 10,500,000

The firm has a target capital structure of 40 percent debt and 60 percent common equity

Hence,

	Limiting Instrument	Value of limiting instrument	Proportion of limiting instrument in capital structure	Total Capital at break point	Debt portion	Equity portion
		A	B	C = A/B	C x 40%	C x 60%
A) Before the firm has to raise new equity.	Equity	10,500,000	60%	17,500,000	7,000,000	10,500,000
B) With the cost of new common equity but before the firm has to borrow at the higher interest rate.	Debt	6,000,000	40%	15,000,000	6,000,000	9,000,000
C) With New cost of equity and at the most expensive cost of debt.	None			Limitless

3. Calculate the Weighted average cost of capital at all the break points found on Question 2 above.

A) Before the firm has to raise new equity.

	$	Proportion	Post tax cost	Component cost
Lower cost debt	6,000,000	34.29%	6%	2.06%
Higher cost debt	1,000,000	5.71%	7.50%	0.43%
Retained earnings	10,500,000	60.00%	13.09%	7.85%
New Equity	-	0.00%	13.40%	0.00%
Total	17,500,000	100.00%		10.34% = WACC

B) With the cost of new common equity but before the firm has to borrow at the higher interest rate.

	$	Proportion	Post tax cost	Component cost
Lower cost debt	6,000,000	40.00%	6%	2.40%
Higher cost debt	-	0.00%	7.50%	0.00%
Retained earnings	-	0.00%	13.09%	0.00%
New Equity	9,000,000	60.00%	13.40%	8.04%
Total	15,000,000	100.00%		10.44% = WACC

C) With New cost of equity and at the most expensive cost of debt.

	Proportion	Post tax cost	Component cost
Lower cost debt	0.00%	6%	0.00%
Higher cost debt	40.00%	7.50%	3.00%
Retained earnings	0.00%	13.09%	0.00%
New Equity	60.00%	13.40%	8.04%
Total	100.00%		11.04% = WACC