Question

XYZ Company has 40% debt 60% equity as optimal capital structure. The nominal interest rate for the company is 12% up to $5 million debt, above which interest rate rises to 14%. Expected net income for the year is $17,5 million, dividend payout ratio is 45%, last dividend distributed was $4,5/share, P0 = $37, g=5%, flotation costs 10% and corporate tax rate is 40%.

a. Find the break points

b. Calculate component costs (cost of each financing source)

c. Calculate WACCs.

d. Two projects are available:

1st. Project requires 15 million initial investments, IRR=18%

2nd. Project requires 10 million initial investments, IRR=12%

Please find the optimal capital budget. (Project(s) to be invested in)

Answer #1

(a) Break Point = Component Break / Component Weight = $5 million/0.4 = $12.5 million

(b) Component Cost : Debt and Equity

Debt:

Cost of debt = interest x (1 - tax rate)

= 12 x(1-0.4)

=7.2%

Cost of equity using DDM Model:(D_{1} / P_{0)}+
g

where, D_{1} = D_{0} (1 + g)

D_{1} = 4.5 (1 + 0.05)= 4.725

Cost of equity =(4.725 / 37) + 0.05 0.18 = 18%

(c) WACC =(0.4 x 7.2%) + (0.6 x 18%) = 13.68%

(d) To select the optimal capital budget or the project to invest in, we always see IRR > Cost of Capital (WACC here)

so, Project 1 is to be selected because it has IRR = 18% which is greater than WACC of 13.68%

Project 2 is not selected since its IRR = 12% which is less than WACC of 13.68%

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