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Finance: WACC with flotation cost.

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WACC, equity from new stock, uses DCF
10. Assume that you are on the financial staff of Christopher Inc., and you have collected the following data: (1) The yield on the companyâ??s outstanding bonds is 7.0%, and its tax rate is 40%. (2) The expected year-end dividend is $0.80 a share, the dividend is expected to grow at a constant rate of 6% a year, the price of Christopher's stock is $25 per share, and the flotation cost for selling new shares is 10%. (3) The target capital structure is 40% debt and 60% equity. What is Christopher's WACC assuming that it must issue new stock to finance its capital budget?

a. 7.11%
b. 7.26%
c. 7.41%
d. 7.67%
e. 7.89%

Here is the basic WACC equation: WdRd(1-T) + WpRp + WcRe. I'm having trouble with the second and third parts of the equation. With WpRp, the problem doesn't specify the weight of preferred stock (Wp). Also, for WcRe, I can't figure out how to calculate Re with a 10% flotation cost. Help!

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Solution Summary

The problem deals with estimating the weighted average cost of capital with flotation costs included.

$2.19
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Cost of Capital Spreadsheet: a. What is the current Kd, Kp and Ke assuming no new debt or stock? And what is the current cost of capital?
b. At what size capital structure will the firm run out of retained earnings?
c. At that point what will the Kne (cost of new common equity) be? And what will the
cost of capital be?
d. At what size of capital structure will the firm's cost of debt change?
e. At that point what will the new Knd (after tax cost of debt) be? And what will
the cost of capital be?
f. Given the above summarized the amounts of financing levels and costs of captial
for each level.
g. Rank the projects from highest returns to lowest.
h. Explain what projects are accepted and why and which are rejected and why?
i. Given your answer to h, what then would be the new FMV's of debt and equities?

Rolling Stone Manufacturing is going to introduce a new product line and to accomplish this it has four projects analyzed in which it wants to invest a total of $100 million. Your job is to find what it will cost to raise this amount of capital and based on the cost of capital determine which of the projects should be accepted by the firm to invest in.
PROJECTS
A B C D
INVESTMENT $30,000,000 $20,000,000 $25,000,000 $25,000,000
EXPECTED RETURN 10.00% 14.00% 11.50% 16.00%

The firms capital structure consists of: FMV
CAPITAL PERCENTAGE AMOUNT
Debt 30% $15,000,000
Preferred stock 10% $5,000,000
Common stock 60% $30,000,000 Includes retained earning
$50,000,000
Other information about the firm:
CORPORATE TAX RATE 35%
DEBT
CURRENT PRICE $900.00
ANNUAL INTEREST 9% INTERST PAID SEMIANNUALLY
ORIGINAL MATURITY 25 YEARS, BUT NOW 20 YEARS LEFT
MATURITY VALUE $1,000.00
FLOTATION COST INSIGNIFICANT
YIELD:
UP TO $25 MILLION Current % (Kd)
ABOVE $25 MILLION 3% additional premium

PREFERRED
CURRENT PRICE $50.00
LAST DIVIDEND $5.00 FIXED AT 10% OF PAR
FLOTATION COST $2.00

COMMON
CURRENT PRICE $33.00
LAST DIVIDEND (Do) $1.50
RETAINED EARNINGS $16,000,000
GROWTH RATE (g) 9%
FLOTATION COST $3.00

NOTE - Once retained earnings is maxed out new common stock will need to be issued.
Any preferred stock would be new preferred stock. May want to review case in chapter eleven.

REQUIRED:
a. What is the current Kd, Kp and Ke assuming no new debt or stock? And what
is the current cost of capital?
b. At what size capital structure will the firm run out of retained earnings?
c. At that point what will the Kne (cost of new common equity) be? And what will the
cost of capital be?
d. At what size of capital structure will the firm's cost of debt change?
e. At that point what will the new Knd (after tax cost of debt) be? And what will
the cost of capital be?
f. Given the above summarized the amounts of financing levels and costs of captial
for each level.
g. Rank the projects from highest returns to lowest.
h. Explain what projects are accepted and why and which are rejected and why?
i. Given your answer to h, what then would be the new FMV's of debt and equities?

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