P13-25 Taunton Construction Inc.’s capital situation is described as follows:
Debt: The firm issued 10,000 25-year bonds10 years ago at their par value of $1,000. The bonds carry a coupon rate of 14% and are now selling to yield 10%.
Preferred Stock: 30,000 shares of preferred stock were sold six years ago at a par value of $50. The shares pay a dividend of $6 per year. Similar preferred issues are now yielding 9%.
Equity: Taunton was initially financed by selling 2 million shares of common stock at $12. Accumulated retained earnings are now $5 million. The stock is currently selling at $13.25.
Taunton‘s Target Capital Structure is as follows:
Preferred Stock 5.0%
Common Equity 65.0%
· Taunton‘s marginal tax rate (state and federal) is 40%.
· Flotation costs average 12% for common and preferred stock.
· Short-term treasury bills currently yield 7.5%.
· The market is returning 12.5%.
· Taunton‘s beta is 1.2.
· The firm is expected to grow at 6% indefinitely.
· The last annual dividend paid was $1.00 per share.
· Taunton expects to earn $5 million next year.
· The firm can borrow an additional $2 million at rates similar to the market return on its old debt. Beyond that lenders are expected to demand returns in the neighborhood of 14%.
· Taunton has the following capital budgeting projects under consideration in the coming year. These represent its investment opportunity schedule (IOS).
Project IRR Required Cap. Req.
A 15.0% $3M $3M
B 14.0% $2M $5M
C 13.0% $2M $7M
D 12.0% $2M $9M
E 11.0% $2M $11M
a. Calculate the firm’s capital structure based on book and market values and compare with the target capital structure. Is the target structure a reasonable approximation of the market value based structure? Is the book structure very far off?
b. Calculate the cost of debt based on the market return on the company’s existing bonds.
c. Calculate the cost of preferred stock based on the market return on the company’s existing preferred stock.
d. Calculate the cost of retained earnings using three approaches, CAPM, dividend growth, and risk premium. Reconcile the results into a single estimate.
e. Estimate the cost of equity raised through the sale of new stock using the dividend growth approach.
f. Calculate the WACC using equity from retained earnings based on your component cost estimates and the target capital structure.
g. Where is the first breakpoint in the MCC (the point where retained earnings runs out)? Calculate to the nearest $.1M.
h. Calculate the WACC after the first breakpoint.
i. Where is the second breakpoint in the MCC (the point at which the cost of debt increases.) Why does this second break exist? Calculate to the nearest $.1M.
j. Calculate the WACC after the second break.
k. Plot Taunton’s MCC.
l. Plot Taunton’s IOS on the same axes as the MCC. Which projects should be accepted and which should be rejected? Do any of those rejected have IRRs above the initial WACC? If so, explain in words why they’re being rejected.
m. What is the WACC for the planning period?
n. Suppose project E is self-funding in that it comes with a source of its own debt financing. A loan is offered through an equipment manufacturer at 9%. The cost of the loan is 9% ´ (1–T) = 5.4%.
Should project E be accepted under such conditions?