Tapley Inc.'s current (target)capital structure has a target debt-to-assets ratio (D/TA)of 60 percent.The firm can raise up to $5 million in new debt at a before-tax cost of 8 percent.If more debt is required,the initial cost will be 8.5 percent,and if more than $10 million of debt is required,the cost will be 9 percent.Net income for the previous year was $10 million,and it is expected to increase by 10 percent this year.The firm expects to maintain its dividend payout ratio of 40 percent on the 1 million shares of common stock outstanding.If it must sell new common stock,it would encounter a 10 percent flotation cost on the first $2 million,a 15 percent cost if more than $2 million but less than $4 million is needed,and a 20 percent cost if more than $4 million of new outside equity is required.Tapley's tax rate is 30 percent,and its current stock price is $88 per share.If the firm has an unlimited number of projects that will earn a 10.25 percent return,what is the maximum capital budget that can be adopted without adversely affecting stockholder wealth?
A) $32.0 million
B) $15.9 million
C) $23.0 million
D) $10.6 million
E) $26.5 million

Question

Quizplus · Accepted Answer

To maintain stockholder wealth, Tapley Inc. should finance new projects up to the point where the cost of new capital equals the return on new investments (10.25%). The firm can raise $5 million at 8%, then up to an additional $5 million at 8.5% before the cost increases to 9%. For equity, the cost increases with the amount raised due to flotation costs. The firm's net income is expected to increase by 10% from $10 million to $11 million, with a 40% dividend payout, leaving $6.6 million to be reinvested. The firm's target debt-to-assets ratio is 60%, indicating a preference for debt financing. Considering these factors, the firm can raise capital through debt and retained earnings without exceeding the 10.25% return threshold, allowing for a capital budget that maximizes stockholder wealth without specifying the exact amount from the provided options.