Question

Sun Products Company (SPC) uses only debt and equity. It can issue bonds at an after-flotation interest rate of 12 percent so long as it finances at its target capital structure, which calls for 45 percent debt and 55 percent common equity. Its last dividend was $2.40, its expected constant growth rate is 5 percent, and its stock sells for $24. A flotation cost of 7% would be required to issue new common stock. SPC’s tax rate is 40 percent. The company expects to earn $200 million in after-tax income during the coming year and will retain 70% of those earnings.

Four projects are available: Project A has a cost of $140 million and an IRR of 13 percent, Project B has a cost of $125 million and an IRR of 12 percent, Project C has a cost of $20 million and an IRR of 11 percent, and Project D has a cost of $50 million and an IRR of 10 percent. All of the company’s potential projects are independent and equally risky.

a. Calculate SPC’s cost (interest rate) of common equity if it finances with retained earnings.

b. Calculate SPC’s cost (interest rate) of common equity if it finances with a new common stock issue.

c. Calculate the maximum capital budget that SPC can support with retained earnings

d. Calculate SPC’s weighted average cost of capital for the scenario where the common equity source is through retained earnings.

e. Calculate SPC’s weighted average cost of capital for the scenario where the common equity source is through a new common stock issue.

f. Determine the optimal capital budget amount for SPC.

Answer 1

Answer a;

if the Project is financed by Retained Earnings: Cost of Reatined earning:-

Dividend1/Price+growth

2.4*1.05/24+5%

15.5%

Answer b:

if project is financed by Common stock issue, its cost increase by the flotation cost that company need not be expend in case of retained earnings

so Cost of equity:- 15.5/(1-0.07)= 16.67%

Answer c:-

Maximum Retained earning that can be used for financing the project = 200*70% = 140 million

Answer D:-

WACC:- supoosing company uses 140 million of Retained earnings and 60 millions of Debt

140/200*.155+60/200*.12*(1-0.4)

.1085+.0216

13.01%