John Henry 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.
The firms capital structure consists of:
Other information about the firm:
CORPORATE TAX RATE
UP TO $25 MILLION
ABOVE $25 MILLION
LAST DIVIDEND (Do)
GROWTH RATE (g)
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.
a. What is the current Kd, Kp and Ke assuming no new debt or stock? And what
is the current cost of capital?
To calculate Kd first calculate the YTM on the bond. The YTM is calculated below.
b. At what size capital structure will the firm run out of retained earnings?
Amount of retained earnings
Proportion of retained earnings in new capital
Maximum amount which can be raised with 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?
The existing cost of debt is applicable till
The capital structure at which debt cost changes
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.
Between $26,666,667 to
g. Rank the projects from highest returns to lowest.
h. Explain what projects are accepted and why and which are rejected and why?
The best project is D. So this project is considered first. The investment required is The WACC for investment upto 26,666,667 is 11.40% and the return on the project is Since return on project is greater than WACC, we accept this project
The best next best project is B. The investment required is
The WACC for investment upto 83,3333,333 is 12.24% and the return on the project is
Since return on project is greater than WACC, we accept this project
The return on project C is 11.50% which is less than the WACC of 12.24%, hence this project is n t selected.
Similarly project A is not selected.
Thus, Project D and B should be accepted.
i. Given your answer to h, what then would be the new FMV’s of debt and equities?