Optimal Capital Budgets
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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?