Question

Whitson Hog Heaven Inc. has the following capital budgeting opportunities this year. The following are the IRR and corresponding investments required by the projects listed below:

Project                                     IRR                      Investment

           

    A                                                     10%                             $1,000

    B                                                     13%                             $3.000

    C                                                     14%                             $2,000

    D                                                     9%                              $5,000

    E                                                      15%                             $9,000

Whitson’s balance sheet is:      Assets     $600,000            Liabilities:   $500,000

                                                                                                      Equity        $100,000

Whitson has available to him 3 sources of debt. Short term debt available of $5,000 and Long-term debt of up to $6,000 and above $6,000. The after-tax cost of these debts in random order are 12%, 10% and 14%. Whitson has earned net income of $10,000 and pays dividends of 0.02 cents a share on 100,000 shares. He will in the future grow that dividends by 10% a year. He can issue new common stock with an underwriting charge of 15%. His share value is determined by his historical equity value on the balance sheet per share.

1. Compute the after-tax component costs of debt based on the normal yield curve risk relationships. 6 points

Kd₁ =

Kd₂ =

Kd₃ =

2. Compute the component cost of Retained earnings and New Common Stock. 4 points

K_{RE =}

K_{NCS =}

3. Compute the points where Whitson’s source of funds run out based on capital spending. (Break points) 3 points

4. What are the Ka’s with their corresponding funding increments? 4 points

$ BRACKET                    FORMULA                                                                          K_a

5. Graph the IOS/MCC schedule. 4 points

6. What is the optimal capital budget? 2 points

7. What happens to Ka when: Make sure to explain your answer. 6 points

a. Market interest rates increase.

b. A firm exceeds it borrowing capacity.

c. The growth rate to dividends is increased.

Answer 1

Soltution:

1.The normal yield curve reflects higher interest rates for longer period debt.A longer period of time increases the probability of unexpected negative events taking place.Therefore long term maturity will typically offer higher interest rates.Thus after-tax costs of debt based on the normal yield curve risk relationships are as follows;

Kd1=10% (since it is short term debt)

Kd2=12%

Kd3=14%