Question

Comprehensive Problem 9-26. Stone Wood Products has a capital structure of 35 percent debt and 65 percent common equity. The managers consider this mix to be optimal and want to maintain it in the future. Net income for the coming year is expected to be $1.2 million dollars. Duke Mantee, the loan officer at the local bank, has set up the following schedule for Stone Wood Products borrowings. There are 40,000 shares of common stock outstanding. The firm's interest subsidy tax rate is 40 percent. For more, see 8e Spreadsheet Templates for Microsoft Excel. Interest Rate Loan Amount $0 to $750,000 >$750,000 10% 12% The market price per share of Stone Wood Products common stock is $50 per share. They have declared a $5 dividend to be paid in one year. The company's expected growth rati is 9 percent. The flotation costs for new common stock issued are set at 8 percent of the market price. The managers are considering several investment opportunities for the upcoming year. They have asked the senior financial analyst, Gabrielle Maple, to recommend which of the following projects the firm should undertake. Because you are the newest member of her team and need the experience, she has passed this management request on to you. Investment Opportunities Project Rate of Return Initial Investment in millions) $0.5 $1.6 $0.6 $1.5 16% 12% 15% 18% a. Calculate all of Stone Wood Products' component costs of capital (after-tax cost of debt, cost of equity, and cost of new equity). b. Calculate all of the MCC break points. c. Calculate all of the MCC figures. d. Make an IOS by listing the projects from the highest to the lowest internal rates of return. e. Plot the MCC values and the IOS values on the same graph. f. Which projects will you recommend management adopt for the next year?

It would be great if you could also list the formulas used. Thank you in advance!

Answer 1

Part A

After tax cost of debt, ATkd (1) = Kd*(1-T) = 10%*(1-40%) = 6% (Excel formula =F23*(1-B29))

After tax cost of debt, ATkd (2) = Kd*(1-T) = 12%*(1-40%) = 7.2% (Excel formula =F24*(1-B29))

Cost of existing equity, ks = D1/P0 + g = 5/50 + 9% = 19% (Excel formula =(B26/B25)+B27)

Cost of new equity, ks = D1/(P0 – F) + g = 5/(50-4) + 9% = 19.87% (Excel formula =(B26/(B25-(B25*B28)))+B27)

Part B

Debt break point = 750000/35% = $2142857.14

Equity break point:

Net income	1200000
- dividends (40000*5)	200000
RE available	1000000

Break point = 1000000/65% = $1538461.54

Part C

MCC up to 1^st break point (equity) = (35%*6%)+(65%*19%) = 14.45%

MCC between 1^st and 2^nd break points = (35%*7.2%)+(65%*19%) = 14.87%

MCC after 2^nd break point = (35%*7.2%)+(65%*19.87%) = 15.44%

Part D

Project	Cost	IRR
D	1500000	18%
A	500000	16%
C	600000	15%
B	1600000	12%

(on the basis of highest-to-lowest IRR)

Part E

15 10 5 1500 4500 500 1000 2000 2500 3000 3500 4000 20

Part F

Project C should be accepted