Question

You are the assistant to Ron Michaels, the budget director for Alpine, Inc. It is early in January 2019 and you just met with him to discuss the capital budget for the year. Ron indicated that Alpine’s CFO restricted total investment for the year to $18 million. Hence, you have to determine in which of the three projects in the following table Alpine should invest.

Project	Investment required	IRR
A	$   14.50 million	7.50%
B	4.50 million	6.70%
C	8.00 million	6.00%

Alpine’s former budget director had used an arbitrary fixed discount (or required) rate to evaluate the firm’s capital budgeting projects. Unfortunately, this led to some “bad calls” and, eventually, the replacement of the former budget director. On the other hand, Ron believes that the Weighted Average Cost of Capital (WACC) should be used to evaluate capital budgeting projects. As a result, he asked you to use flotation costs and market value weights of debt and equity to estimate the Marginal Cost of Capital (MCC) and use it to decide in which of the three projects Alpine should invest.

In the meeting you asked Ron how Alpine will raise the money needed for its capital budget. Ron indicated that the money will be raised from Alpine’s 2018 retained earnings and from the sale of new bonds and stocks. With respect to earnings retention, in 2018 Alpine’s net income was $10 million and its retained earnings $3 million. In addition, Alpine expects its annual dividends per share of common stock to grow at seven percent for ever. Regarding the sale of new securities, Ron recommended that new securities be sold in a way that does not change the current market value weights of debt and equity in Alpine’s capital structure. Presently, Alpine has (i) 28 million shares of common stock outstanding with a $13.25 market price each and (ii) 200,000 bonds outstanding each having a $912.50 market price, five years to maturity, $1,000 par value, and three percent annual coupon rate (interest is paid semi-annually).

Alpine’s investment banker has informed Ron that there will be no flotation costs for any amount of new bonds the firm decides to sell. However, if the firm decides to sell new stocks the investment banker will charge flotation costs equal to 12% of the stock’s selling price for an amount of new equity up to $9 million and 20% of the stock’s selling price for any new equity amount in excess of $9 million. The investment banker assured Ron that new bonds and stocks will have the same characteristics and sell at the same prices as Alpine’s currently outstanding bonds and stocks. Alpine’s tax rate is 35%.

Ron will meet with Alpine’s CFO in about an hour and wants you to determine:

(a)        What are the weights of debt and equity in Alpine’s capital structure?                 

(b)       What is the total financing supported by Alpine’s retained earnings?

Answer 1

A) As it is clearly given in the question the present capital structure of Alpine is 28 Million shares of common stock and 200000 bonds. Therefore, the weights of Debt and equity or Debt:Equity ratio is 200000:2800000 i.e., 1:14, which means for each one debt the company has 14 shares as capital structure.

B) Out of Total financing of $18 Million, Retained Earnings cumulate of about $3 Millions i.e., Retained Earning contribute of about 16.67% of total financing of $18 million.