Transcript Optimal Capital Budgets

New Equity Issuance
 Cost of External Equity



 Ex. Suppose Archer’s Aquarium Equipment may continue to issue
unlimited amounts of common equity at a floatation cost of 8%. The firm
recently paid a common stock dividend of $3 per share, and the firm’s
dividends are expected to grow by 3% per annum. If the firm’s current
stock price is $40 per share, what is the cost of external equity for Archer’s
Aquarium Equipment?
Weighted Average Cost of Capital
 Given an optimal capital structure of 60% common equity,
30% debt, and 10% preferred stock, what is Archer’s
Aquarium Equipment’s weighted average cost of capital
(WACC) for capital budgets in excess of $50 million?
Optimal Capital Budget
 Investment Opportunity Schedule (IOS) -
 Ex. Archer’s Aquarium Equipment can select among the
following projects:
Project
A
B
C
D
E
Cost
$20 mil.
$5 mil.
$15 mil.
$10 mil.
$15 mil.
Return
11.50%
11.00%
10.50%
10.00%
9.50%
Optimal Capital Budget
%
New Capital Raised
 Which projects should Archer’s Aquarium Equipment
undertake?
Comprehensive Example
 Ex. Ling’s Libation Barn has 4 potential capital investment projects with the following
costs and rates of return:
Project
Vermont Apple Vodka
Minnesota Moonshine
Rhode Island Rot Gut
California Cabernet
Cost
$200,000
$300,000
$500,000
$750,000
Return
15.0%
14.0%
13.0%
12.0%
 LLB estimates it can issue debt with a before-tax cost of 10 percent, and its marginal
federal-plus-state tax rate is 30 percent. Ling’s Libation Barn may also issue preferred
stock at $50 per share, which pays a constant dividend of $5 per year. The floatation cost
on preferred stock issuance is $1 per share.
 In addition, net income is expected to be $250,000, and the firm plans to maintain its
current dividend payout ratio of 40%. The firm’s stock is currently selling for $40 per
share. The year-end dividend (D1) is expected to be $3.50, and the dividend growth rate is
expected to be constant at 6% per year into the foreseeable future. Floatation costs of
issuing new common stock equal $4 per share (F=10%), and LLB’s optimal capital
structure consists of 75% common equity, 15% debt, and 10% preferred stock.
Retained Earnings Break Point
What is LLB’s retained earnings break point?
Capital Component Costs
 What is LLB’s component cost of debt?
 What is LLB’s component cost of preferred stock?
 What is LLB’s component cost of retained earnings?
 What is LLB’s component cost of new common equity?
Weighted Average Cost of Capital
What is LLB’s weighted average cost of capital
for capital budgets <$200,000?
What is LLB’s weighted average cost of capital
for capital budgets > $200,000?
Optimal Capital Budget
What should be the size of LLB’s optimal
capital budget?