Question

The Financial controller of “BESTH Co.” is about to select among three available projects. He was provided the following information:

Project   Rate of return
X   12.10 %
Y   11.80%
Z   12.95%
BESTH Co. has a capital structure that consists of $15,000 debt, $10,000 preferred stock, $40,000 internal common equity from retained earnings, and $35,000 external common equity through issuing new shares that would incur a 10% flotation cost.

The company estimates that it can issue debt at a before tax cost of 9%, and its tax rate is 40%. The company can also issue preferred stock at $60 per share, which pays a constant dividend of $6 per year.

The company’s common stock currently sells at $30 per share. The year-end dividend, D1, is expected to be $2.50, and the dividend is expected to grow at a constant rate of 6% per year.
1. BESTH Co. weight of debt is: *
A. $10,000
B. 15%
C. 57.14%
D. 42.86%
E. None of the above

2. BESTH Co. weight of internal common equity from retained earnings is: *
A. 35.00%
B. 40.00%
C. 35,000
D. $40,000
E. None of the above

3. BESTH Co. weight of external common equity is: *
A. 35.00%
B. 40.00%
C. 35,000
D. $40,000
E. None of the above

4. BESTH Co. weight of preferred equity is: *
A. 35.00%
B. 40.00%
C. 10.00%
D. $10,000
E. None of the above

5. The after-tax cost of debt for BESTH Co. is: *
A. 9.0%
B. 5.4%
C. 7.5%
D. 6.0%
E. None of the above

6. The cost of internal equity for BESTH Co. is: *
A. 14.0%
B. 13.5%
C. 12.5%
D. 14.33%
E. None of the above

7. The cost of external equity for BESTH Co. is: *
A. 21.50%
B. 10.29%
C. 15.26%
D. 100.00%
E. None of the above

8. The cost of preferred equity for BESTH Co. is: *
A. 10%
B. 34.78%
C. 65.22%
D. 9.00%
E. None of the above

9. BESTH Co. weighted average cost of capital (WACC) is: *
A. 65.22%
B. 12.48%
C. 6.00%
D. 75.00%
E. None of the above

10. The project(s) that can be accepted by the company is(are): *
A. Only Y
B. Only X
C. Only Z
D. All of them
E. None of them

Answer 1

1). weight of debt = debt amount/total capital (using internal equity) = 15,000/(40,000+15,000+10,000) = 23.08%

weight of debt (using external equity) = 15,000/(35,000+15,000+10,000) = 25.00%

Option E is correct.

2).weight of internal equity = 40,000/65,000 = 61.54%  Option E is correct.

3). weight of external equity = 35,000/60,000 = 58.33% Option E is correct.

4). weight of preferred equity (using internal equity) = 10,000/65,000 = 15.38%

weight of preferred equity (using external equity) = 10,000/60,000 = 16.67%

Option E is correct.

5). After-tax cost of debt = pre-tax cost of debt*(1-Tax rate) = 9%*(1-40%) = 5.40% Option B is correct.

6). Cost of internal equity = (D1/P0) + g = (2.5/30) + 6% = 14.33% Option D is correct.

7). Cost of external equity = (D1/(P0*(1-flotation cost)) + g = (2.5/(30*(1-10%))) + 6% = 15.26%

Option C is correct.

8). Cost of preferred equity = annual dividend/price per share = 6/60 = 10% Option A is correct.

9). WACC = (weight of equity*cost of equity) + (weight of debt*cost of debt) + (weight of preferred stock*cost of preferred stock)

WACC (using retained earnings) = (weight of equity*cost of retained earnings) + (weight of debt*cost of debt) + (weight of preferred stock*cost of preferred stock)

= (61.54%*14.33%) + (23.08%*5.40%) + (15.38%*10%) = 11.61%

WACC (using new common stock) = (weight of equity*cost of new common stock) + (weight of debt*cost of debt) + (weight of preferred stock*cost of preferred stock)

= (58.33%*15.26%) + (25%*5.40%) + (16.67%*10%) = 11.92%

Option E is correct.

10). A project is accepted when its rate of return (IRR) is greater than the required return.

Project X and Z are acceptable since both have IRR's greater than the company WACC.

Project Y is acceptable only if retained earnings are used when WACC will be 11.61%. So, all three projects are acceptable. Option D is correct.