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

Solution: 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 k_e = $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 k_a1 = 0.7(0.148) + 0.3(0.10)0.6 = 0.122 k_a2 = 0.7(0.153) + 0.3(0.10)0.6 = 0.125 k_a3 = 0.7(0.156) + 0.3(0.10)0.6 = 0.127 k_a4 = 0.7(0.156) + 0.3(0.12)0.6 = 0.131

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