The following table give EPS figures for the "B" Company during the preceding 10 years. The firm's commons stock - 7.8 million shares outstanding - is currently (January 1, 2008) is 55 percent of the 2008 EPS. Because investors expect past rends to continue, g can be based on the earnings growth rate. Nine years of growth follows:
Current interest rate on new debt is 9 percent. The firm's marginal tax rate if 20 percent. Its capital structure, considered to be optimal, is as follows:
Common equity 156,000,000
Total liabilities and equity $260,000,000
a. Calculate the "B" Company after-tax cost of new debt and of common equity, assuming that the needed equity funds come only from retained earnings. Calculate the cost of equity as:
Ks = D1/P0 + g.
b. Find "B" Company's weighted average cost of capital, assuming that no new common stock is sold and that all debt cost 9 percent.
c. How much can the firm spend on capital investments before it must sell external equity? (Assume that the retain earnings available for 2008 represent 45 percent of 2008 earnings. Obtain 2008 earnings by multiplying the expected 2008 EPS by the shares outstanding.)
d. What is "B" Company's weighted average cost of capital - that is, the cost of funds raised in excess of the amount calculated in par (c) - if new common stock can be sold to the public at $65 per share to net the firm $58.50 per share? The cost of debt is constant.
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The solution examines current interest rates and capital investments fir a company preceding 10 years.