Question

On January 1, the total market value of the Tysseland Company was $60 million. During the year, the company plans to raise and invest $25 million in new projects. The firm's present market value capital structure, shown below, is considered to be optimal. Debt Common equity Total capital $30,000,000 30,000,000 $60,000,000 The current price of firm's 15-year, 12% coupon, semiannual payment noncallable bonds is $1,153.72. New bonds will be privately placed with no flotation cost. Common stock is currently selling at $30 a share. The stockholders' required rate of return is The stockholders' required rate of return is estimated to be 12%, consisting of a dividend yield of 4% and an expected constant growth rate of 8%. (The next expected dividend is $1.20, so $1.20/$30 = 4%.) The marginal corporate tax rate is 35%. a. In order to maintain the present capital structure, how much of the new investment must be financed by common equity? Explain. b. Assuming there is sufficient cash flow such that Tysseland can maintain its target capital structure without issuing additional shares of equity, what is its WACC? c. How would firm's WACC be affected by the need to issue additional shares of equity in the external capital markets?

Answer 1

a) New investment financed by equity = 50% x 25 = $12.5 million as 50% of the current capital structure is equity.

b) Cost of equity, re = 12%, Cost of debt, rd can be calculated using RATE function in excel

rd = RATE(15 x 2, 12% x 1000 / 2, -1,153.72, 1000, 0) x 2 = 10.00%

WACC = we x re + wd x rd x (1 - tax) = 50% x 12% + 50% x 10% x (1 - 35%) = 9.25%

c) Firm's WACC will increase as the cost of equity will increase due to flotation cost associated with raising equity.