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Maintain Present Capital Structures

Financial Management 2

Cost of capital Problem

At the end of 199x Caribbean yachting products had $ 100 million total net assets. Management desires to increase its production machinery during 199x by $20 million in order to provide for new product lines. Bond financing will be at an 8% rate and will sell at par. Preferred stock will e sold at a par value of $ 100 and will have a 10% dividend payment. Common stock, which currently is selling for $50 a share, can be sold to net the company $45 after flotation costs, Internal funding available from retained earnings is estimated to be $ million

Caribbean estimates that its. Stockholders require a 20% rate of return on capital.

The marginal corporate income tax rate is 40%

Caribbean's present capital structure listed below is considered optimal.

Debt $25million
Preferred Stock $25 millions
Common Equity
Common Stock $30 million
Retained Earnings $20 million
TOLTAL

Questions.

1. In order to maintain the present capital structure, how much of the new capital must be financed by equity (common & retained earnings.

2. How much of the equity financing must come from the sale of new common stock?

3. What is Caribbean's weighted average cost capital?

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Solution Preview

Financial Management:
Questions.

1. In order to maintain the present capital structure, how much of the new capital must be financed by equity (common & retained earnings).
Answer)
First we find out the total funding need.
Additional funding required is $20 million.
Secondly, as the current capital structure is optimal, we only have to replicate it. So, we find what percentage of the current capital structure is equity (common & retained earning). This is (30+20)/(25+25+30+20) or 0.5.
Hence, half of the additional funding need will be financed by equity, which is 0.5*20 or $10 million

2. How much of the equity financing must come from the sale of new common stock?
Answer)
We calculated in part 1 that $10 million will be financed by equity (common and retained earnings).
We are supposed to maintain the same capital structure, so the question boils down to, how do we preserve the same ratio as we previously had?
The ratio (common stock/equity) before and after financing must be the same. Hence,
30/(20+ 30) = x/10
Or x = $6 million. This amount must be financed by the sale of new common stock.

3. What is Caribbean's weighted average cost capital?
Answer)
What is the total amount before financing that is raised from the capital market?
The amount is = Debt + Preferred Stock + Common Stock = 25+25+30 or $80 million.
As we are not changing the capital structure so the WACC ...

Solution Summary

The expert examines maintaining present capital structures. The Caribbean's weighted average cost capital is given.

$2.19