Lancaster Engineering Inc. (LEI) has the following capital structure, which Lancaster Engineering Inc. (LEI) has the following capital structure, which it considers to be optimal: Debt ……………………………. 25% Preferred stock …………………. 15 Common equity ………………… 60 100% LEI’s expected net income this year is $34,285.72; its established dividend payout ratio is 30 percent; its marginal tax rate is 30 percent; and investors expect earnings and dividends to grow at a constant rate of 9 percent in the future. LEI paid a dividend of $3.60 per share last year, and its stock currently sells at a price of $60 per share. LEI can obtain new capital in the following ways: Common stock: New common stock has a flotation cost of 10 percent for up to $12,000 of new stock and 20 percent for all common stock over $12,000. Preferred stock: New preferred stock with a dividend of $11 can be sold to the public at a price of $100 per share, however, flotation costs of $5 per share will be incurred for up to $7,500 of preferred stock, and flotation costs will rise to $10 per share, or 10 percent, on all preferred stock over $7,500. Debt: Up to $5,000 of debt can be sold at an interest rate of 12 percent; debt in the range of $5,001 to $10,000 must carry an interest rate of 14 percent; and all debt over $10,000 will have an interest rate of 16 percent. LEI has the following independent investment opportunities:
a. Find the break points in the MCC schedule. b. Determine the cost of each capital structure component. c. Calculate the WACC in the interval between each break in the MCC schedule. d. Calculate the expected return for Project E. e. Construct a graph showing the MCC and IOS schedules. f. Which projects should LEI accept?
Solutions:
Retained Earnings after tax= 34,285.72X(1-.3) = Tk. 24,000 Break Points for Retained Earnings = 24,000/0.6 = 14,400 Cost of Retained Earnings (ROE) = g/(1-pay-out ratio) = .09/.7 =12.8% Break Points for common stock = 12,000/0.6 = 20,000 Cost of common stock for upto 12,000 new stocks = {3.60/(60-60X10%)} + 0.09 = 15.6% Cost of common stock for over 12,000 new stocks = {3.60/(60-60X20%)} + 0.09 = 16.5% Break Points for Preferred stocks= 7500/.15 = 50,000 Cost of Pref. stock upto 7,500 = 11/(100-5) = 11.6% Cost of Pref. stock over 7,500 = 11/(100-10) = 12.2% Break Points for Debts = 5,000/.25 = 20,000 Break Points for Debts = 10,000/.25 = 40,000 Cost of debts upto 5000 debts = 12%X(1-.3) = 8.4% Cost of debts between 5000 and 10000 debts = 14%X(1-.3) = 9.8% Cost of debts Over 10000 debts = 16%X(1-.3) = 11.2% The Break points are 14,400; 20,000; 40,000; 50,000 WACC in Break Points: Range
Source of Capital
% of Capital
0-14400
Retained Earnings
.60
14401-20000
Debt Common Stock
.25 .60
20001-40000
Debt Common Stock
.25 .60
40001-50000
Debt Pref. Stock Common Stock
.25 .15 .60
50000+
Debt Pref. Stock Common Stock
.25 .15 .60
Cost of Capital 12.8% Overall cost of capital 8.4% 15.6% Overall cost of capital 9.8% 16.5% Overall cost of capital 11.2% 11.6% 16.5% Overall cost of capital 11.2% 12.2% 16.5% Overall cost of capital
Considering Cost of capital at 20%, the NPV
= 5427.84 X PVIFA20%,6 – 20,000 = 5427.84X 3.3255 – 20,000 = -1949.72
Considering Cost of capital at 10%, the NPV
= 5427.84 X PVIFA10%,6 – 20,000 = 5427.84X 4.3553 – 20,000 = 3639.87
Weighted 7.68% 7.68% 2.1% 9.36% 11.46% 2.1% 9.9% 12.0% 2.8% 1.74% 9.9% 14.44% 2.8% 1.83% 9.9% 14.53%
By using interpolation technique, IRR for Project E = 10% + {(3639.87 X 10%)/(3639.87+1949.72)} = 10% + 6.5% = 16.5% Since Project B has the highest return, so the project B can be accepted.
