Anderson Company has four investment opportunities with the following costs (all costs are paid at t=0) and estimated internal rates of return (IRR):
Project Cost IRR -
A $2,000 16.0%
B $3,000 14.5 -
C $5,000 11.5 -
D $3,000 9.5 -
The company has a target capital structure, which consists of 40 percent common equity, 40 percent debt, and 20 percent preferred stock. The company has
$1,000 in retained earnings. The company expects its year-end dividend to be $3.00 per share. The dividend is expected to grow at a constant rate of 5 percent a year. The company's stock price is currently $42.75. If the company issues new common stock, the company will pay its investment bankers a 10 percent flotation cost. The company can issue corporate bonds with a yield to maturity of 10 percent. The company is in the 35 percent tax bracket. How large can the cost of preferred stock be (including flotation costs) and it still be profitable for the company to invest in all four projects?
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A. B. C. D. E.D
We need to find k(ps) at the point where all 4 projects are accepted. In other words, the capital budget = $2,000 + $3,000 + $5,000 + $3,000 = $13,000. The
WACC at that point is equal to IRR(D) = 9.5%.
Step 1 Find the retained earnings break point to determine whether k(s) or k(e) is used in the WACC calculation:
BP(RE) = $2,500.
Since the capital budget > the retained earnings break point, k(e) is used in the WACC calculation.
Step 2 Calculate k(e):
k(e) = [3.00/$42.75(1-.10)] + 5% = 12.80%.
Step 3 Find k(ps):
9.5% = 0.4(10%)(0.65) + 0.2(kps) + 0.4(12.80%)
9.5% = 2.60% + 0.2(kps) + 5.12%
1.78% = 0.2k(ps)
8.90% = k(ps).