Question

SCROLL TO THE BOTTOM!!!

For starters, the capital structure for the past year of operations is:

Mortgage bonds (Debt): $2,000

Debentures (Debt): 1,500

Retained earnings (Equity): 500

1. What is the current financial mix (this was in the Cost of Capital video lecture)?

Answer: 0.875 : 0.125

The president informed you that DWOTT has chosen to raise capital by issuing stocks and bonds in the ratio of 6.5:3.5.

2. What does that mean for your company (in other words, their target is no more than 35% debt…how does that relate to where they currently are? Can they afford to take on more debt)?

The company can afford to have more debt amount in its capital structure provided that the cost of debt does not exceed than the cost of equity, in other words, Capital structure should combine various sources of finance into an optimum capital mix, involving the least average cost of capital and in this way helping in maximizing of returns for company in long-run.

He also wants to know the WACC and has given you the following information about your capital budgeting:

The 20 year $1000 par value mortgage bonds were sold at $952.67 and pay 8%. They had a $47.67 flotation cost.

3. What is the cost of the mortgage bonds?

Answer: 9.04%

The 15 year $500 par value debentures were sold at $486.50 and pay 6%. They had a $26.50 flotation cost.

4. What is the cost of the debentures?

Answer: 6.87%

DWOTT paid a dividend of $.80 last year and expects them to grow 15% next year and into the foreseeable future. The stock currently trades at $36.70.

5. What is the cost of retained earnings?

Answer: 17.51%

6. What is the weighted average cost of capital?

Answer: 9.29%

Now the president is starting to get on your nerves. But, whaddayagonnado? He is the president. You just wish he wasn’t so demanding. Nevertheless, you press on. He has informed you that you need to aid in a decision regarding a new facility. There are 3 mutually exclusive locations being considered each with it’s own startup cost and projected cash flows as shown below:

	Timbuktu	Neverland	Middle Earth
Cost	$3,600	$8,750	$6,500
Year 1 CF	$0	$4,000	$2,000
Year 2 CF	0	4,000	2,000
Year 3 CF	0	1,500	2,000
Year 4 CF	0	0	2,000
Year 5 CF	$8,500	3,000	3,000

The president has asked for a thorough analysis. Keeping in mind DWOTT’s cost of capital (use WACC above)(9.29%), what decision should be made regarding the projects above using each of the following tools:

7. What is each project's payback period and which would you choose?

Timbuktu: 4.42 years

Neverland: 2.50 years

Middle Earth: 3.25 years

Choice & Why? Based on the above calculations, the Neverland project should be accepted as it has the lowest payback period.

8. What is each project's discounted payback period and which would you choose?

Timbuktu: 4.66 years

Neverland: 4.31 years

Middle Earth: 4.03 years

Choice & Why? Based on the above calculations, the Middle Earth project should be accepted as it has the lowest discounted payback period.

9. What is each project's net present value and which would you choose?

Timbuktu: $1,851.51

Neverland: $1,332.01

Middle Earth: $1,862.47

Choice & Why? Based on the above calculations, the Middle Earth project should be accepted as it has the highest NPV.

10. What is each project's internal rate of return and which would you choose?

Timbuktu: 18.75%

Neverland: 16.36%

Middle Earth: 19.22%

Choice & Why? Based on the above calculations, the Middle Earth project should be accepted as it has the highest IRR.

11. What is each project’s modified internal rate of return and which would you choose?

Timbuktu: 18.75%

Neverland: 14.02%

Middle Earth: 11.15%

Choice & Why? Based on the above calculations, the Timbuktu project should be accepted as it has the highest MIRR.

12. Considering the WACC and given the calculations above, which project do you prefer, and why?

I would prefer Middle Earth because it was the best choice in most of the categories above.

Now that you have decided which location you will move forward with, you must determine how you will raise the capital. You have done some research and come up with 3 options:

PREFERRED STOCK: DWOTT can sell preferred stock for $21 per share. The preferred stock pays an annual dividend of 3.5% based on a par value of $100. Flotation costs associated with the sale of preferred stock equal $1.25 per share. The company's marginal tax rate is 35%.

13. Therefore, the cost of preferred stock is:

Answer: 17.72%

Would this work? Why or why not?

COMMON STOCK: Another option available to DWOTT is to sell common stock for $27 per share and just paid a divided of 3.79. The company expects a constant growth rate of 8%. However, the administrative or flotation costs associated with selling the stock amount to $2.70 per share.

14. What is the cost of capital for DWOTT if the corporation raises money by selling common stock?

Answer: 16.8%

Would this work? Why or why not?

BONDS: Finally, you could finance the new location by issuing new 10-year, $1,000 par, 9% annual coupon bonds. The market price of the bonds is $625 each. The flotation expense on the new bonds will be $50 per bond. DWOTT is in the 35% tax bracket.

15.What is the pre-tax & after-tax cost of debt for the newly-issued bonds?

Answer: 17.07% & 11.10%

Would this work? Why or why not?

16. Which of these options is realistic given what you know about the chosen location and your financial mix?

I just need the 13-15 "Would this work? Why or Why Not?" questions and 16 question answered.

All number answers are correct.

Answer 1

Would this work? Why or why not?

13. This would work. As the project which is selected have the IRR of 19.22% which is higher than the cost of Preference Stock 17.72%, hence the project will result in positive NPV.

14. This would work. As the project which is selected have the IRR of 19.22% which is higher than the cost of Common Stock 16.8%, hence the project will result in positive NPV.

15. This would work. As the project which is selected have the IRR of 19.22% which is higher than the after tax cost of Debt is 11.10%, hence the project will result in positive NPV.

16. Thogh the cost of the debt is lowest, the most practical option will be to issue common stock because the company already has huge amount of debt. It is better to issue common stock to finance the new project as this would help the company to get better financial mix.