Question

Whitson Hog Heaven Inc. has the following capital budgeting opportunities this year. The following are the IRR and corresponding investments required by the projects listed below:

Project                                     IRR                      Investment

           

    A                                                     10%                             $1,000

    B                                                     13%                             $3.000

    C                                                     14%                             $2,000

    D                                                     9%                              $5,000

    E                                                      15%                             $9,000

Whitson’s balance sheet is:      Assets     $600,000            Liabilities:   $500,000

                                                                                                      Equity        $100,000

Whitson has available to him 3 sources of debt. Short term debt available of $5,000 and Long-term debt of up to $6,000 and above $6,000. The after-tax cost of these debts in random order are 12%, 10% and 14%. Whitson has earned net income of $10,000 and pays dividends of 0.02 cents a share on 100,000 shares. He will in the future grow that dividends by 10% a year. He can issue new common stock with an underwriting charge of 15%. His share value is determined by his historical equity value on the balance sheet per share.

1. Compute the component cost of Retained earnings and New Common Stock. 4 points

K_{RE =}

K_{NCS =}

2. Compute the points where Whitson’s source of funds run out based on capital spending. (Break points) 3 points

3. Graph the IOS/MCC schedule. 4 points

4. What is the optimal capital budget? 2 points

5. What happens to Ka when: Make sure to explain your answer. 6 points

a. Market interest rates increase.

b. A firm exceeds it borrowing capacity.

c. The growth rate to dividends is increased.

Answer 1

Soltuion:

1.a)Calculation of Cost of New common stock

Issue of new common stock involved flotation cost i.e underwriting charge at rate of 15%

Share price=Value of equity/no. of shares

=$100,000/100,000 shares

=$1 per share

Dividend of next year(D1)=Current year dividend(1+growth rate)

=($1*0.02)*(1+.10)

=$0.022

Cost of equity=[D1/Share Price(1-flotation rate)]+growth rate

=[$0.022/$1(1-0.15)]+0.10

=($0.022/$0.85)+0.10

=0.1259 or 12.59%

b)Cost of retained earning

retained earning does not involve flotation cost,thus we can use following formula to calculate cost of retained earning

cost retained earning=D1/share price+growth rate

=($0.022/$1)+0.10

=0.122 or 12.20%

Thus;

KRE =12.20%

KNCS =12.59%