Advanced financial management revision question and answer

Lancaster Engineering Inc. (LEI) has the following structure, which it considers to be optimal:

Debt 25%
Preferred stock 15
Common equity 60
100%

LEI‟s expected net income this year is Sh.34,285.72; its established dividend payout ratio is 30 percent; its marginal tax rate is 40 percent; and investors expect earnings and dividends to grow at a constant rate of nine percent in the future. LEI paid a dividend of Sh.3.60 per share last hear, and its stock currently sells at a price of Sh.60 per share.

LEI can obtain new capital in the following ways:

Common: New common stock has a flotation cost of ten percent for up to Sh.12,000 of new stock and 20percent for all common stock over Sh.12,000.

Preferred: New preferred stock with a dividend of Sh.11 can be sold to the public at a price of Sh.100 pershare. However, flotation costs of Sh.5 per share will be incurred for up to Sh.7,500 of preferred stock, and flotation costs will rise to Sh.10 per share, or ten percent, on all preferred stock over Sh.7,500.

Debt: Up to Sh.5,000 of debt can be sold at an interest rate of 12 percent; debt in the range of Sh.5,001 toSh.10,000 must carry an interest rate of 14 percent; and all debt over Sh.10,000 will have an interest rate of 16 percent.

LEI has the following independent opportunities:

(a) Find the break points in the MCC schedule
(b) Determine the cost of each capital structure component.
(c) Calculate the weighted average cost of capital in the interval between each break in the MCC schedule.
(d) Calculate the IRR for Project E.
(e) Construct a graph showing the MCC and IOS schedules.
(f) Which projects should LEI accept?
ANSWER
(a) A break point will occur each time a low-cost type of capital is used up. We establish the break points as follows, after first noting that LEI has Sh.24,000 of retained earnings:

There are three common equity costs and hence two changes and, therefore, two equity-induced breaks in the MCC. There are two preferred costs and hence one preferred break. There are three debt costs and hence two debt breaks.

The numbers in the third column of the table designate the sequential order of the breaks, determined after all the break points were calculated. Note that the second debt break and the break for retained earnings both occur at sh.40,000.

The first break point occurs at Sh.20,000, when the 12 percent debt is used up. The second break point, Sh.40,000, results from using up both retained earnings and the 14 percent debt. The MCC curve also rises at Sh.50,000 and Sh.60,000, as preferred stock with a 5 percent flotation cost and common stock with a 10 percent flotation cost, respectively are used up.

(b) Component costs within indicated total capital intervals are as follows: Retained earnings (used in interval Sh.0 to Sh.40,000):

(f) LEI should accept Projects B, E, and C. It should reject Projects A and D because their IRRS do not exceed the marginal costs of funds needed to finance them. The firm‟s capital budget would total Sh.40,000.

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