Medical Research Corporation is expanding its research and
production capacity to introduce a new line of products. Current
plans call for the expenditure of $100 million on four projects of
equal size ($25 million each), but different returns. Project A is
in blood clotting proteins and has an expected return of 18
percent. Project B relates to a hepatitis vaccine and carries a
potential return of 14 percent. Project C, dealing with a
cardiovascular compound, is expected to earn 11.8 percent, and
Project D, an investment in orthopedic implants, is expected to
show a 10.9 percent return.
The firm has $26,000,000 in retained earnings. After a capital
structure with $26,000,000 million in retained earnings is reached
(in which retained earnings represent 60 percent of the financing),
all additional equity financing must come in the form of new common
stock.
Common stock is selling for $26 per share and underwriting
costs are estimated at $2.7 if new shares are issued. Dividends for
the next year will be $0.41 per share (D1), and earnings and
dividends have grown consistently at 12% percent per year.
The yield on comparative bonds has been hovering at 10
percent. The investment banker feels that the first $20,000,000 of
bonds could be sold to yield 10 percent while additional debt might
require a 2 percent premium and be sold to yield 12 percent. The
corporate tax rate is 30 percent. Debt represents 40 percent of the
capital structure.
a.
Based on the two sources of financing, what is the initial
weighted average cost of capital? (Use Kd and Ke.) Round your
response to two decimal places.
b.
At what size capital structure will the firm run out of
retained earnings? Round your response to the nearest whole
dollar.
c.
What will the marginal cost of capital be immediately after
that point? Round your response to two decimal places.
d.
At what size capital structure will there be a change in the
cost of debt? Round your response to the nearest whole
dollar.
e.
What will the marginal cost of capital be immediately after
that point? Round your response to two decimal places.