Question

Rolodex Inc. is in the process of determining its capital budget for the next fiscal year. The firm's current capital structure, which it considers to be optimal, is contained in the following balance sheet: Note: For this problem, use the book value of the items to get the capital structure. However, you normally want to use the market values. Long-term debt is the only debt capital structure account. Add common stock, capital in excess of par, and RE to get common equity. Rolodex Inc. Balance Sheet (in Millions of Dollars) Current assets $105 Accounts payable $ 35 Fixed assets Other current liabilities 25 255 Total assets $360 Long-term debt 90 Preferred stock 60 Common stock (15 million shares at par) 15 30 Contributed capital in excess of par Retained earnings 105 $ 360 Total liabilities and equity Discussions between the firm's financial officers and the firm's investment and commercial bankers have yielded the following information: Rolodex can borrow $15 million from its bank at a pretax cost of 11 percent. Rolodex can borrow $85 million by issuing bonds at a net price of $938 per bond. The bonds would carry a 13 percent coupon rate and mature in 15 years Additional debt can be issued at a 15 percent pretax cost Preferred stock can be issued at a pretax cost of 17 percent. Rolodex expects to generate $120 million in net income and pay $1 per share in dividends

Answer 1

1)	Existing capital structure:	Value		Weight
	Debt	$         90.00	million	30.00%
	Preferred stock	$         60.00	million	20.00%
	Common stock = 15+30+105 =	$       150.00	million	50.00%
	Total	$       300.00	million	100.00%
2)	Weight on debt	30.00%
3)	Before tax cost of debt for the second class of debt = YTM of the bonds.
	YTM [using an online calculator] =	14.01%
	After tax cost of the second class of debt = 14.01%*(1-40%) =	8.41%
4)	Internal cost of equity = 1/14+0.065 =	13.64%
5)	External cost of equity = 1/12+0.065 =	14.83%
6)	Lowest break even point:
	With debt 15/30% [based on bank borrowings] =	$         50.00	million
	With retained earnings = (120-15)/50% =	$       210.00	million
	Lowest break even point =	Debt
7)	Marginal cost of capital schedule:
	First increment:
	Break point [based on bank borrowing]	$         50.00	million
	WACC = 11%*(1-40%)*30%+13.64%*50%+17%*20% =	12.20%
	Second increment:
	Break point with debt [based on bank borrowing+bonds] = 100/30% =	$       333.33	million
	So, break point with retained earnings of $210 million should be used.
	WACC = 8.41%*30%+13.64%*50%+17%*20% =	12.74300%
	Third increment:
	Break point with bank borrowings + bonds	$       333.33	million
	WACC = 8.41%*30%+14.83%*50%+17%*20% =	13.34%
	[External equity would be used]
	Additional funds:
	CEB beyond $333.33 million, with external equity
	and additional debt.
	WACC = 15%*30%+14.83%*50%+17%*20% =	15.32%