Far Out Tech (FOT) has a debt ratio of 0.3, and it considers this to be its optimal capital structure. FOT has no preferred stock. FOT has analyzed four capital projects for the coming year as follows: $$\begin{array} { l l l }
\text { Project } & \text { Net Investment } & \text { IRR } \
1 & \$ 3,000,000 & 13.5 \% \
2 & \$ 1,500,000 & 18.0 \% \
3 & \$ 2,000,000 & 12.6 \% \
4 & \$ 1,600,000 & 16.0 \%
\end{array}$$ ? FOT expects to earn $2.7 million after tax next year and pay out $700,000 in dividends. Dividends are expected to be $1.05 a share during the coming year and are expected to grow at a constant rate of 10% a year for the foreseeable future. The current market price of FOT stock is $22 and up to $2 million in new equity can be raised for a flotation cost of 10%. If more than $2 million is sold then the flotation cost will be 15%. Up to $2 million in debt can be sold at par with a coupon rate of 10%. Any debt over $2 million will carry a 12% coupon rate and be sold at par. If FOT has a marginal tax rate of 40%, in which projects should it invest?

Question

Far Out Tech (FOT) has a debt ratio of 0.3, and it considers this to be its optimal capital structure. FOT has no preferred stock. FOT has analyzed four capital projects for the coming year as follows: $$\begin{array} { l l l } 
\text { Project } & \text { Net Investment } & \text { IRR } \
1 & \$ 3,000,000 & 13.5 \% \
2 & \$ 1,500,000 & 18.0 \% \
3 & \$ 2,000,000 & 12.6 \% \
4 & \$ 1,600,000 & 16.0 \%
\end{array}$$ ? FOT expects to earn $2.7 million after tax next year and pay out $700,000 in dividends. Dividends are expected to be $1.05 a share during the coming year and are expected to grow at a constant rate of 10% a year for the foreseeable future. The current market price of FOT stock is $22 and up to $2 million in new equity can be raised for a flotation cost of 10%. If more than $2 million is sold then the flotation cost will be 15%. Up to $2 million in debt can be sold at par with a coupon rate of 10%. Any debt over $2 million will carry a 12% coupon rate and be sold at par. If FOT has a marginal tax rate of 40%, in which projects should it invest?

Quizplus · Accepted Answer

FOT should invest in projects with an IRR higher than its cost of capital. Given the optimal debt ratio (0.3) and no preferred stock, the cost of capital is influenced by the cost of debt and equity. The cost of debt before reaching $2 million is 10%, and after $2 million, it's 12%, but with a 40% tax rate, the after-tax costs are 6% and 7.2%, respectively. The cost of equity can be estimated using the dividend discount model (given dividends, growth, and stock price), but since the IRRs for projects 2 and 4 are significantly higher than typical costs of capital and project 1's IRR is also above typical benchmarks, they are likely to exceed the firm's cost of capital. Project 3's IRR is lower and closer to the cost of debt, making it less clearly beneficial, especially considering the cost of new equity or higher-cost debt that might be needed to finance it. Therefore, projects 1, 2, and 4 are chosen, assuming they exceed the firm's weighted average cost of capital.

Far Out Tech (FOT) Has a Debt Ratio of 0