The following information pertains to the capital program of a firm:
Target capital structure: 30% debt, 20% preferred stock, 50% equity.
Unadjusted component costs of capital
k_d = 10%
k_p = 12%
k_e = 14%
Flotation Costs, Taxes, and Retained Earnings
Flotation costs are 8% on common and preferred stock and zero on debt
The total effective tax rate (federal and state) is 40%
Retained earnings of $1,250,000 are expected next year.
Investment Opportunities
$\begin{array}{lll}\text { Project } & \text { Investment } & \underline{\text { IRR }} \\\hline \text { A } & \text { \$1 million } & 13.0 \% \\\text { B } & \$ 2 \text { million } & 12.5 \% \\\text { C } & \$ 3 \text { million } & 11.8 \% \\D & \$ 1 \text { million } & 11.0 \%\end{array}$ a. Adjust the component costs of capital for taxes and flotation costs, and calculate the WACC before and after the first break.
b. Calculate the location of the break point.
c. Sketch the MCC and the IOS on the same graph. What is the cost of capital for the year? Why?
d. Which projects should the firm undertake? Why?

Question

The following information pertains to the capital program of a firm:
Target capital structure: 30% debt, 20% preferred stock, 50% equity.
Unadjusted component costs of capital
k_d = 10%
k_p = 12%
k_e = 14%
Flotation Costs, Taxes, and Retained Earnings
Flotation costs are 8% on common and preferred stock and zero on debt
The total effective tax rate (federal and state) is 40%
Retained earnings of $1,250,000 are expected next year.
Investment Opportunities

\begin{array}{lll}\text { Project } & \text { Investment } & \underline{\text { IRR }} \\\hline \text { A } & \text { \$1 million } & 13.0 \% \\\text { B } & \$ 2 \text { million } & 12.5 \% \\\text { C } & \$ 3 \text { million } & 11.8 \% \\D & \$ 1 \text { million } & 11.0 \%\end{array}

a. Adjust the component costs of capital for taxes and flotation costs, and calculate the WACC before and after the first break.
b. Calculate the location of the break point.
c. Sketch the MCC and the IOS on the same graph. What is the cost of capital for the year? Why?
d. Which projects should the firm undertake? Why?

Quizplus · Accepted Answer

The Answer of The following information pertains to the capital program of a firm: Target capital structure: 30% debt, 20% preferred stock, 50% equity. Unadjusted component costs of capital k_d = 10% k_p = 12% k_e = 14% Flotation Costs, Taxes, and Retained Earnings Flotation costs are 8% on common and preferred stock and zero on debt The total effective tax rate (federal and state) is 40% Retained earnings of $1,250,000 are expected next year. Investment Opportunities $\begin{array}{lll} \text { Project } & \text { Investment } & \underline{\text { IRR }} \ \hline \text { A } & \text { \$1 million } & 13.0 \% \ \text { B } & \$ 2 \text { million } & 12.5 \% \ \text { C } & \$ 3 \text { million } & 11.8 \% \ D & \$ 1 \text { million } & 11.0 \% \end{array}$ a. Adjust the component costs of capital for taxes and flotation costs, and calculate the WACC before and after the first break. b. Calculate the location of the break point. c. Sketch the MCC and the IOS on the same graph. What is the cost of capital for the year? Why? d. Which projects should the firm undertake? Why?

The Following Information Pertains to the Capital Program of a Firm