Gibson Inc. is considering the following five independent projects:
Project RequiredAmount of CapitalIRR
A$20 0,000 20%
B600,000 15 -
C400,000 12 -
D400,000 11 -
E400,000 10 -
The company has a target capital structure, which is 40 percent debt and 60 percent equity. The company can issue bonds with a yield to maturity of 11 percent.
The company has $600,000 in retained earnings, and the current stock price is $42 per share. The flotation costs associated with issuing new equity are $2 per share. Gibson's earnings are expected to continue to grow at 6 percent per year. Next year's dividend is forecasted to be $4.00. The firm faces a 40 percent tax rate. What is the size of Gibson's capital budget?
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A. B. C. D. E.C
The size of Gibson's capital budget will be determined by the number of projects it can profitably undertake, i.e., those projects for which IRR > applicable WACC.
First, find the costs of each type of financing: cost of retained earnings = k(s) = $4/$42 + 0.06 = 15.52% and cost of debt = k(d) = 11%. To calculate the cost of new equity, we solve for k(e) = $4/($42-$2) + 0.06 = 0.16 = 16%. Given the firm's target capital structure and its retained earnings balance of $600,000, the firm can raise $1,000,000 with debt and retained earnings before it must use outside equity. Therefore, the WACC for 0 - $1,000,000 of financing = 0.4(0.11)(1 - 0.4) +
0.6(0.1552) = 11.95%. Above $1,000,000, the firm must issue some new equity, so the WACC = 0.4(0.11)(1 - 0.4) + 0.6(0.16) = 12.24%. Obviously, Projects A and B will be undertaken. You must then determine whether Project C will be profitable. Since in taking A and B we will need financing of $800,000, the $400,000 needed for Project C would involve financing $200,000 with debt and retained earnings and $200,000 with debt and new equity. Thus, the WACC for Project C is
($200,000/$400,000) x 0.1195 + ($200,000/$400,000) x 0.1224 = 12.095% which is greater than Project C's IRR. Clearly, only Projects A and B should be accepted, and the firm's capital budget is $800,000.