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 $15 million in retained earnings. After a capital structure with $15 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 $25 per share and underwriting costs are estimated at $3 if new shares are issued. Dividends for the next year will be $.90 per share (D1), and earnings and dividends have grown consistently at 11 percent per year.

The yield on comparative bonds has been hovering at 11 percent. The investment banker feels that the first $20 million 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. explain)

Answer 1

Kd = cost of debt -(before tax)		11%
Kd after tax =	Before tax cost*(1-tax rate)	11*(1-.3)	7.7
Ke cost of equity	(expected dividend/market price)+growth rate	(.9/25)+11%	14.60%
expected dividend		0.9
market price		25
growth rate		11%
Initial WACC
source	weight	cost of source	weight*source
debt	0.4	7.7	3.08
equity	0.6	14.6	8.76
Initial WACC	sum of weight*source		11.84