Question

The Longenes Company uses a target capital structure when calculating the cost of capital. The target structure and current component costs based on market conditions follow. Component

Component	Mix	Cost*
Debt	25%	8%
Preferred Stock	10	12
Common Equity	65	20

The costs of debt and preferred stock are already adjusted for taxes and/or flotation costs. The cost of equity is unadjusted.

The firm expects to earn $20 million next year and plans to invest $18 million in new capital projects. It generally pays dividends equal to 60% of earnings. Flotation costs are 10% for common and preferred stock.

a. What is Longenes's initial WACC? Round the answer to two decimal places.___ %

b. Where is the retained earnings breakpoint in the MCC? Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round the answer to one decimal place.___ $ million

c. What is the new WACC after the break? (Adjust the entire cost of equity for flotation costs.) Round the answer to two decimal places. ___%

d. Longenes can borrow up to $4 million at a net cost of 8% as shown. After that the net cost of debt rises to 12%. What is the new WACC after the increase in the cost of debt? Round the answer to two decimal places.__ %

e. Where is the second break in the MCC? That is, how much total capital has been raised when the second increase in WACC occurs? Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round the answer to the nearest whole. __$ million

Answer 1

Ans.

a)

Component	Mix (a)	Cost (b)	Factors (a*b)
Debt	25%	8%	2.00%
Preferred Stock	10%	12%	1.20%
Common Equity	65%	20%	13.00%
		WACC	16.20%

b)

Retention Ratio = (1- Dividend Payout ratio) = 1 - 0.6 = 0.4 or 40%

Available retained earnings = $ 20Milliom × 40% = $8 Million

Breakpoint = $ 8Million/ 0.65 = $12.3 Million

c)

Cost of new equity = ke / ( 1 - 0.1)  = 20% /0.9 = 22.2%

Component	Mix	Cost	Factors
Debt	25%	8%	2.0%
Preferred Stock	10%	12%	1.2%
Common Equity	65%	22.2%	14.4%
		WACC	17.6%

d)

Component	Mix	Cost	Factors
Debt	25%	12%	3.0%
Preferred Stock	10%	12%	1.2%
Common Equity	65%	22.2%	14.4%
		WACC	18.6%

e)

The second break in the MCC

$ 4M/0.25 = $16M