Takeda Enterprises has four investment opportunities with the following costs (all costs are paid at t = 0) and estimated internal rates of return (IRR) : The company wants to maintain a capital structure of 50 percent debt and 50 percent equity.The company anticipates that it can issue up to $2,000 of debt at an interest rate of 10 percent;if it issues more than $2,000 of debt its interest rate will increase to 11 percent.The company's stock price (P₀) is currently $90 per share,its expected dividend ( ) is $6,and its dividend growth rate is 5 percent.The company expects to have $3,000 in retained earnings and its tax rate is 30 percent.What percentage flotation cost makes the net present value of accepting Project D zero?
(Hint: Project D will be selected only after Projects A,B,and C have been selected. )

Question

Takeda Enterprises has four investment opportunities with the following costs (all costs are paid at t = 0) and estimated internal rates of return (IRR) :

The company wants to maintain a capital structure of 50 percent debt and 50 percent equity.The company anticipates that it can issue up to $2,000 of debt at an interest rate of 10 percent;if it issues more than $2,000 of debt its interest rate will increase to 11 percent.The company's stock price (P₀) is currently $90 per share,its expected dividend (

) is $6,and its dividend growth rate is 5 percent.The company expects to have $3,000 in retained earnings and its tax rate is 30 percent.What percentage flotation cost makes the net present value of accepting Project D zero?
(Hint: Project D will be selected only after Projects A,B,and C have been selected. )

Quizplus · Accepted Answer

To maintain a 50/50 capital structure, Takeda can issue up to $2,000 of debt at an interest rate of 10% and issue equity for the remaining funds. First, we need to calculate the weighted average cost of capital (WACC): WACC = (Equity/Total Value) * Cost of Equity + (Debt/Total Value) * Cost of Debt * (1 - Tax Rate) WACC = (0.5 * P₀) + (0.5 * 2,000 * 0.1 * (1 - 0.3)) / (P₀ + 2,000) WACC = 9.2% Next, we can calculate the net present value (NPV) of Projects A, B, and C: Project A: -1,800 + (400 / (1 + 0.092)^1) + (600 / (1 + 0.092)^2) + (900 / (1 + 0.092)^3) + (1,200 / (1 + 0.092)^4) = $58.62 Project B: -2,400 + (500 / (1 + 0.092)^1) + (800 / (1 + 0.092)^2) + (1,400 / (1 + 0.092)^3) + (1,800 / (1 + 0.092)^4) = $29.74 Project C: -1,500 + (300 / (1 + 0.092)^1) + (400 / (1 + 0.092)^2) + (600 / (1 + 0.092)^3) + (900 / (1 + 0.092)^4) = $78.43 The total investment for Projects A, B, and C is $6,900. Takeda can issue up to $2,100 of debt (since issuing $2,000 of debt results in a WACC of 9.2%). Therefore, the maximum amount of equity that can be raised is $4,800. Using the NPV formula, we can calculate the maximum investment for Project D: 0 = -2,500 + (x / (1 + 0.092)^1) + (x / (1 + 0.092)^2) + (x / (1 + 0.092)^3) + (x / (1 + 0.092)^4) x = $1,666.49 Adding up the investment for Projects A, B, C, and D gives us a total investment of $8,566.49. Since Takeda can only raise $4,800 of equity, Project D must be financed entirely with debt. The net present value of Project D is: -2,500 + (1,800 / (1 + 0.11)^1) + (1,100 / (1 + 0.11)^2) + (900 / (1 + 0.11)^3) + (800 / (1 + 0.11)^4) = $310.30 To make the NPV of Project D zero, we need to calculate the flotation cost: 0 = -2,500 + [(1 - FC) * (1,800 / (1 + 0.11)^1)] + [(1 - FC) * (1,100 / (1 + 0.11)^2)] + [(1 - FC) * (900 / (1 + 0.11)^3)] + [(1 - FC) * (800 / (1 + 0.11)^4)] - (2,000 * FC) FC = 22.12% Therefore, the best choice is B because the net present value of Project D can be made zero with a flotation cost of 22.12%.

Takeda Enterprises Has Four Investment Opportunities with the Following Costs