Question

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 $23,000,000 in retained earnings. After a capital structure with $23,000,000 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 $22 per share and underwriting costs are estimated at $2.7 if new shares are issued. Dividends for the next year will be $0.51 per share (D1), and earnings and dividends have grown consistently at 12% percent per year.

The yield on comparative bonds has been hovering at 11 percent. The investment banker feels that the first $22,000,000 of bonds could be sold to yield 11 percent while additional debt might require a 2 percent premium and be sold to yield 13 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.

Answer 1

Stock price = Expected Dividend/(Cost of Retained Earnings – growth rate)

22 = 0.51/(Cost – 12%)

Cost of retained earnings = 14.32%

Stock price – Flotation Cost = Expected Dividend/(Cost of new Stock – Growth rate)

22 – 2.7 = 0.51/(Cost of new Stock – 12%)

Cost of new stock = 14.64%

Initial Weighted average cost of capital = Cost of debt*Weight of debt + Cost of Equity*Weight of Equity

= 11%*40% + 14.32%*60%

= 12.992%

i.e. 12.99%

b.Capital Structure = Amount in retained earnings/Share of Equity

= 23,000,000/60%

= $38,333,333.33

c.Marginal cost of capital = 11%*40% + 14.64%*60%

= 13.184%

i.e. 13.18%

d.Change in cost of debt = 22,000,000/40%

= $55,000,000

e. MCC = 13%*40% + 14.64%*60%

= 13.984%

i.e. 13.98%