Anderson Company has four investment opportunities with the following costs (all costs are paid at t = 0)and estimated internal rates of return (IRR): The company has a target capital structure which consists of 40 percent common equity,40 percent debt,and 20 percent preferred stock.The company has $1,000 in retained earnings.The company expects its year-end dividend to be $3.00 per share .The dividend is expected to grow at a constant rate of 5 percent a year.The company's stock price is currently $42.75.If the company issues new common stock,the company will pay its investment bankers a 10 percent flotation cost.The company can issue corporate bonds with a yield to maturity of 10 percent.The company is in the 35 percent tax bracket.How large can the cost of preferred stock be (including flotation costs)and it still be profitable for the company to invest in all four projects?

Question

Anderson Company has four investment opportunities with the following costs (all costs are paid at t = 0)and estimated internal rates of return (IRR):  The company has a target capital structure which consists of 40 percent common equity,40 percent debt,and 20 percent preferred stock.The company has $1,000 in retained earnings.The company expects its year-end dividend to be $3.00 per share .The dividend is expected to grow at a constant rate of 5 percent a year.The company's stock price is currently $42.75.If the company issues new common stock,the company will pay its investment bankers a 10 percent flotation cost.The company can issue corporate bonds with a yield to maturity of 10 percent.The company is in the 35 percent tax bracket.How large can the cost of preferred stock be (including flotation costs)and it still be profitable for the company to invest in all four projects?

Quizplus · Accepted Answer

To determine the cost of preferred stock that still allows the company to invest in all four projects, we need to calculate the weighted average cost of capital (WACC) for the company. 
First, we calculate the cost of equity using the dividend discount model:
Re = (D1 / P0) + g
Re = (3.00 * 1.05) / 42.75 + 0.05 = 0.128 or 12.8%
To account for flotation costs, we adjust the cost of issuing new common stock:
Re = 0.128 / (1 - 0.10) = 0.142 or 14.2%
Next, we calculate the cost of debt:
Rd = 0.10
Since the company is in the 35% tax bracket, the after-tax cost of debt is:
Rda = Rd * (1 - tax rate) = 0.10 * (1 - 0.35) = 0.065 or 6.5%
Finally, we calculate the cost of preferred stock:
Rp = ?
Assuming flotation costs of 5%, the cost of preferred stock is:
Rp = (Dp / Np) + F
where Dp is the preferred dividend, Np is the net preferred proceeds, and F is the flotation cost percentage. 
Since we want to find the maximum cost of preferred stock that still allows the company to invest in all four projects, we set up the following equation:
0.4(Re)(1 - F) + 0.4(Rda) + 0.2(Rp)(1 - F) = WACC
Substituting the given values, we have:
0.4(0.142)(1 - 0.10) + 0.4(0.065) + 0.2(Rp)(1 - 0.05) = WACC
Simplifying and solving for Rp, we get:
Rp = 0.089 or 8.9%
Therefore, the cost of preferred stock (including flotation costs) can be as high as 8.9% and the company can still invest in all four projects.

Anderson Company Has Four Investment Opportunities with the Following Costs