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:

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 percent 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 percent.If more than $2 million is sold then the flotation cost will be 15 percent.Up to $2 million in debt can be sold at par with a coupon rate of 10 percent.Any debt over $2 million will carry a 12 percent coupon rate and be sold at par.If FOT has a marginal tax rate of 40 percent, 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:

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 percent 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 percent.If more than $2 million is sold then the flotation cost will be 15 percent.Up to $2 million in debt can be sold at par with a coupon rate of 10 percent.Any debt over $2 million will carry a 12 percent coupon rate and be sold at par.If FOT has a marginal tax rate of 40 percent, in which projects should it invest?

Quizplus · Accepted Answer

Break point for common equity = $2,000,000/0.7 = $2,857,143
Second equity break point = $4,000,000/0.7 = $5,714,286
Debt break point = $2,000,000/0.3 = $6,666,667
kₑ = $1.05/$22 + 0.10 = 0.148
k′ₑ₁ = $1.05/$19.80 + 0.10 = 0.153 k′ₑ₂ = $1.05/$18.70 + 0.10 = 0.156
kₐ₁ = 0.7(0.148) + 0.3(0.10)0.6 = 0.122
kₐ₂ = 0.7(0.153) + 0.3(0.10)0.6 = 0.125
kₐ₃ = 0.7(0.156) + 0.3(0.10)0.6 = 0.127
kₐ₄ = 0.7(0.156) + 0.3(0.12)0.6 = 0.131

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