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(4)

($l0,000,000)(0.08)+ ($50,000,000)(0.10) = $800,000 + $5,000,000= $5,800,000

( 5 ) Required earnings before interest and taxes:

+ $5,800,000= $65,800,000

$60,000,000

Old earnings before interest and taxes:

(6)

(7) Additional before interest and taxes earnings required:

Projected earnings $65,800,000

Old earnings 54,800,000

$11,000,000

10.17 The MCC and 10s Schedules, Rhonda Pollak Company is considering three investments whose

initial costs and internal rates of return are given below:

Internal Rate of Return ( O h )

Project Initial Cost ($)

19

A 100,000

15

B 125,000

12

C 225,000

The company finances all expansion with 40 percent debt and 60 percent equity capital. The

after-tax cost is 8 percent for the first $100,000, after which the cost will be 10 percent. Retained

earnings in the amount of $150,000 is available, and the common stockholders' required rate of

return is 18 percent. If the new stock is issued, the cost will be 22 percent.

302 COST OF CAPITAL [CHAP. 10

Calculate ( a ) the dollar amounts at which breaks occur, and (6) calculate the weighted cost

of capital in each of the intervals between the breaks. (c) Graph the firm's weighted marginal cost

of capital (MCC) schedule and investment opportunities schedule (10s). (d) Decide which

projects should be selected and calculate the total amount of the optimal capital budget.

SOLUTION

Breaks (increases) in the weighted marginal cost of capital will occur as follows:

(a)

For debt:

For common stock:

Retained earnings - $150,000

--= $250,000

Equity/assets 0.6

The debt break is caused by exhausting the lower cost of debt, while the common stock break is caused

by using up retained earnings.

(b) The weighted cost of capital in each of the intervals between the breaks is computed as follows:

With $&$250,000 total financing:

Weighted Cost

cost

Source of Capital Weight

3.2%

8Yo

Debt 0.4

10.8

Common stock 18%

0.6

k, = 14.0%

With over $250,000 total financing:

Source of Capital Weight cost Weighted Cost

4.0%

Debt 0.4 10%

13.2

Common stock 22Yo

0.6

k = 17.2%

See Fig. 10-2.

(c)

(d) Accept projects A and B for a total of $225,000, which is the optimal budget.

16

c

10s

C

( dL

5

t

o

L 1

300400

' 500

New financing (thousands of dollars)

Fig. 10-2

COST OF CAPITAL 303

CHAP. 101

10.18 The MCC and 10s Schedules. John Constas & Company has to decide which of the following

four projects should be selected:

Project Initial Investment ($) Internal Rate of Return (%)

A 250,000 16

B 300,000 10

100,OOO

C 12

D 13

150,000

The company has the following capital structure:

Debt (long-term only) 30%

70%

Equity

The company's last earnings per share was $400.

It pays out 50 percent of its earnings as dividends. The company has $210,000 of retained

earnings available for investment purposes. The cost of debt (before taxes) is 10 percent for the

first $180,000.The cost of any additional debt (before taxes) is 14 percent. The company's tax rate

is 40 percent; the current market price of its stock is $43; the flotation cost is 15 percent of the

selling price; the expected growth rate in earnings and dividends is 8 percent.

(a) How many breaks are there in the MCC schedule, and at what dollar amounts do the

breaks occur? (6) What is the weighted cost of capital in each of the intervals between the breaks?

(c) Graph the MCC and 10sschedules. ( d )Which projects should the company accept and what

is the total amount of the optimal capital budget?

SOLUTION

(a) There are two breaks in the MCC schedule:

- $210,000

Retained earnings --=

For common stock: $300,000

Equityhsets 0.7

- $180,000

Debt --=

For debt: $600,000

0.3

Debtlassets

(b) The weighted cost of capital in each of the intervals between the breaks is calculated as follows:

With O$ - $300,000:

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