ABC Manufacturing is going to introduce a new product line

ABC 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.

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INVESTMENT
EXPECTED RETURN

A
$30,000,000
10.00%

The firms capital structure consists of:
CAPITAL
DEBT
PREFERRED STOCK
COMMON STOCK

PROJECTS
B
$20,000,000
14.00%
PERCENTAGE
30%
10%
60%

Other information about the firm:
CORPORATE TAX RATE

C
$25,000,000
11.50%

D
$25,000,000
16.00%

FMV
AMOUNT
$15,000,000
$5,000,000
$30,000,000
$50,000,000

30%
DEBT
CURRENT PRICE
$1,050.00
ANNUAL INTEREST
6.00% CURRENT INTEREST PAID SEMIANNUALLY
ORIGINAL MATURITY
25 YEARS, BUT NOW 20 YEARS LEFT
MATURITY VALUE
$1,000.00
FLOTATION COST
INSIGNIFICANT
MARKET YIELD PROJECTED:
UP TO $20 MILLION
9%
ABOVE $20 MILLION
12% 3 % additional premium
CURRENT PRICE

PREFERRED
$45.00

LAST DIVIDEND (D0)
FLOTATION COST

$3.38 FIXED AT 7.5% OF PAR
$1.50

NEXT DIVIDEND (D1)

$3.38

CURRENT PRICE
LAST DIVIDEND (D0)
RETAINED EARNINGS
GROWTH RATE (g)
FLOTATION COST
NEXT DIVIDEND (D1)

COMMON
$35.00
$1.00
$10,000,000
9%
$1.50
$1.090

NOTE ­ Once retained earnings is maxed out new common stock will need to be issued.
Any preferred stock would be new preferred stock. You may want to review case in chapter 11.
REQUIRED:
In all of the required parts one part builds on the previous part. If you can’t do a part use the
set of other numbers to solve the next part.
a. What is the current Kd, Kp and Ke assuming no new debt or stock?
b. Since any new capital investment will require issuing new perferred stock, what would the
the new returns be preferred stock (knp) and the new cost of capital?
c. What amount of increase (marginal cost of capital) in capital structure will the firm run
out of retained earnings and be forced to issue new common stock?
d. If new common stock has to be issued what will the new return required be (Kne) and the
new cost of capital?
Note: All Answers Should Be Taken Out to 2 Decimal Places, Especially the Interest Rate Answers.
Part a
Current price
Maturity value
Interest payment
Payment periods
Yield rate
Annual yield
Kd
Kp
Ke
Current Cost of capital

six month rate
annual rate

Can’t really use the current cost of capital since accepting any new projects will require issuing new
Preferred stock requiring a rate higher than its current 7.5% yield.
Part b
Use your solutions in Part a to do this part, but if you couldn’t complete Part a, assume Kd=4%, Kp=8%, and Ke=13%; =
Knp preferred stock
New cost of capital
Part c
If the capital structure increases more than
new common stock will have to be issued to finance new projects since internally generated RE runs out,
and the required return on common stock will increase as demanded by shareholders.
Part d
Kne common stock
If you could not come up with the Kne common stock returns, do the cost of capital assuming Kd=5%, Knp=9%, and Ke=14%=
New cost of capital