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On January 1, 2019, the total assets of the McGarvey Company were $270 million. The first present capital structure, which follows, is considered optimal. Assume that they have no short-term debt.

Long-term debt $135,000,000

Common Equity 135,000,000

Total Liabilities and Equity $270,000,000

New bonds will have a 10% coupon rate and will be sold at par. Common stocks are currently selling at $60 a share, can be sold to net the company $54 a share. Stockholders required rate of return is estimated to be 12%, consisting of a dividend yield of 4% and an expected growth rate of 8% (the next expected dividend is $2.4 so $2.4/$60 = 4%). Retained earnings are estimated to be $15 million. The marginal corporate tax rate is 20%. Assuming that all asset expansion (Gross expenditure plus fixed assets plus related working capital) is included in the capital budget, the amount of the capital budget, ignoring depreciation, is 160,000,000

1. To maintain the present capital structure, how much capital budget must McGarvey finance by equity?

2. How much of the new equity funds needed will be generated internally and externally?

3. Calculate the cost of each of the equity components. 4. Calculate WACC.

Answer 1

1. From the given capital structure, it is clear that there is a 50% equity and 50% debt.

So, the amount of capital budget that must be raised from equity = 0.5* 160,000,000 = 80,000,000

2. Since the retained earnings are estimated at 15 Million, the amount of funds that will be generated internally is 15 million. The amount of funds that will be generated externally is 80-15 = 65 Million.

3. Cost of internal equity = D1/P0 + g = 2.4/60 + 0.08 = 0.12= 12%

Cost of external equity = D1/P0 + g . In external equity P0 = 54 since the firm can get only $54 if it sells new shares.

Cost of external equity = D1/P0 + g = 2.4/54 + 0.08 = 0.12444 = 12.44%

4. WACC = Cost of debt * Weight of debt * (1- tax rate) + cost of internal equity * Weight of internal equity + Cost of external equity *weight of external equity

WACC = 10%*(1-0.2)*80/160 + 12%*15/160 + 12.44%*65/160 = 9.75%

WACC = 9.75%