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Calculating Marginal Cost of Capital and Optimal Capital Budget

Problem 1

S & P Corporation (SPC) has an optimal capital structure of 45 percent debt and 55 percent equity. Given the following information, calculate the marginal cost of capital (MCC) schedule and the optimal capital budget (e.g. how much is the optimal capital budget and what is the corporate cost of capital?).

• 5 years ago, the company issued non-callable bonds that pay semiannual payment with 6.50% annual coupon rate and sold them at par value ($1,000). However, each bond is currently selling at 960 and has 25 years remaining to maturity.

• SPC’s current stock price is $41.03, its long run growth rate is 4.0% and its expected earnings per share (EPS1) is $4.0. The company retains 20% of its earnings to fund future growth.

• There are 102.5 million common shares outstanding.

• New common stock may be issued with 5 percent flotation costs.

• The marginal tax rate is 26%.

• SPC has the following Investment Opportunity Schedule (IOS):

Project IRR Cost (millions)

A 15.2% 20

B 12.5% 55

C 9.0% 45

D 7.5% 40

E 6.0% 50

S & P Corporation (SPC) is considering entering a new line of business. In analyzing the potential business, the financial staff has accumulated the following information:

• The new business will require a capital expenditure of $6.5 million at t = 0. This expenditure will be used to purchase new equipment.

• This equipment will be depreciated according to MACRS seven-year class (see table on next page).

• The equipment will have a salvage value of $500,000 after seven years

The required level of working capital is 5.0% of expected sales over the year:

WCt = 5.0% *Salest+1

• The new business is expected to have an economic life of seven years.

• The Marketing Department forecasts to sell 300,000 units during the first year and then 400,000 units thereafter. The expected price is $10 per unit during the first year. Price must be adjusted by inflation in subsequent years.

• Variable cost is expected to be $5.00 per unit whereas fixed cost is $100,000. These figures must be adjusted by inflation in subsequent years.

• The new product is expected to increase before-tax cash flows of the company’s existing products by $300,000 per year in real terms. This amount also has to be adjusted by inflation.

• The expected inflation rate during the life of the project is 2% per year.The company’s interest expense each year will be $220,000.

• The company’s tax rate is 26%.

• The company is very profitable, so any accounting losses on this project can be used to reduce the company’s overall tax burden.

• The company’s cost of capital (WACC) is 9.10%. However, the proposed project is riskier than the average project for SPC and therefore you have to add 2% to the corporate cost of capital.

The company’s CFO wants you to analyze the project and to write a short report with your recommendation. Please be advised that both financial and non-financial managers will read the report; therefore, make sure you explain your calculations and recommendation.

MACRS 7-year class

Year Depreciation Rates (%)

1 14.3

2 24.5

3 17.5

4 12.5

5 8.9

6 8.9

7 8.9

8 4.5

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