ACCT 2040 / FN 2040 Financial Management SLOA

Problem Introduction Tab

This financial planning project is split into several parts
Each section has its own tab.
Section
Problem Introduction TAB
This tab
Gustafson Financial Information TAB
You will find all the given data here
1 Cost of Capital : Capital Structure TAB
This section is split into two tabs: Cost of Capital A and Cost of Capital B
Cost of Capital A concentrates on the developing Gustafson Capital Structure
Problem:
a) Calculate the firm's capital structure based on book and market values and compare with the target capital structure.
2 Cost of Capital: WACC TAB
Cost of Capital B concentrates on calculating Gustafson's WACC
b) Calculate the cost of debt based on the market return on the company's existing bonds.
c) Calculate the cost of preferred stock based on the market return on the company's existing preferred stock
d) Calculate the cost of retained earnings using three approaches, CAPM, dividend growth, and risk premium.
Reconcile the results into a single estimate
e) Estimate the cost of equity raised through the sale of new stock using the dividend growth approach
f) Calculate the WACC using equity from retained earnings based on your component cost estimates and the target capital structure
3 Capital Rationing: Finding the Breakpoints TAB
This section calculate the breakpoints
g) Where is the first breakpoint in the MCC (the point where retained earnings runs out)? Calculate to the nearest $.1M.
h) Calculate the WACC after the first breakpoint.
i) Where is the second breakpoint in the MCC (the point at which the cost of debt increases.)
j) Calculate the WACC after the second break. Calculate to the nearest $0.1M.
4 MCC - IOS Plot TAB
In this section we plot the Marginal Cost of Capital and the Investment Opportunity Schedule
This tab MCC-IOS is to be used as a template for your graphs
Use the Commands Insert>line and Insert>rectangle to create your plot
k) Plot Gustafson's Marginal Cost of Capital.
l) Plot Gustafson's IOS on the same axes as the MCC.
5 Capital Planning TAB
In this section, we analyze our data and make our conclusions
m) Which projects should be accepted and which should be rejected?
n) Do any of those rejected have IRRs above the initial WACC? Which ones?
o) If so, explain in words why they're being rejected.
p) What is the WACC for the planning period?

Answers are to be entered in the black outlined, yellow boxes

Supporting data is to be entered in the underlined yellow boxes.
Enter all percentages as decimals

Gustafson Gutters Financial Data

Debt
issued
18,000
30 year
at
$
1,000.00 par value with
similar bonds now selling at
Preferred Stock
issued
20,000 shares
at
$
100.00 par value
with dividend of
$6
similar preferred issues are now selling at
Equity
issued
2,300,000 shares at $
Accumulated retained earning is now $
stock closed at
$ 11.25

bonds

10 years ago
5% coupon rate

4%

6 years ago

5%

9.50
5,000,000.00

Torborg's Target Capital Structure

Debt
35%
Preferred
5%
Equity
60%
Additional Financial Information
Marginal Tax Rate
Floatation coasts average
Short Term Treasury yields
Market return is
Gustafson beta is
Indefinite expected growth:
Last annual dividend
$
Expected next years' earnings
$
Firm can borrow up to
$
lenders will demand

35%
11% for both common and preferred stock
2.5%
8.5%
0.9
3%
0.50 per share
5,000,000.00
3,500,000.00 at market return of old debt
7% for borrowing beyond

Investment Opportunity Schedule

Project
A
B
C
D

IRR
14%
8%
6%
5%

Capital Requirement
$
3,000,000.00
$
2,500,000.00
$
2,000,000.00
$
1,000,000.00

Cost of Capital: Capital Structure TAB

score
A

Calculate the firm's capital structure based on book and market values and compare with the target capital structure.
Debt:

Book Value
of Debt
$ 18,000,000.00

Market Value
of Debt
$ 20,461,993.13

Number of Bonds Issued

18,000

Excel:

Bond Face Value

$
1,000.00

Bond Price using Excel PV formula

1,137

X
X

Number of Bonds Issued

18,000

Preferred:

Book Value of
Preferred Stock
$
2,000,000.00

Market Value of
Preferred Stock =
$
2,400,000.00 =

=
=

Preferred Stock
Face Value
$
100.00

X
X

Preferred Stock Issued

20,000

PV of a Perpetuity (Dp/k)
(
(

Dividend (Dp) /
$
6.00 /

Market Rate (k)

0.05

)
)

X
X

Preferred
Stock Issued
20,000

Equity:

Book Value of
Equity
$ 31,450,000.00

=
=

(
(

Common
Stock issued
2,300,000.00

X
X

Market Value of
Equity
$ 21,850,000.00

=
=

(
(

Common
Stock issued
2,300,000.00

X
X

Issue
Price
$
11.50

Market
Price
9.5

)
)

)
)

+
+

Retained
Earnings
5,000,000.00

Part 1
page 2

Cost of Capital
Capital Structure Comparison:
Book
Value
Debt
Preferred
Equity
6

total

$
$
$
$

18,000,000.00
2,000,000.00
31,450,000.00
51,450,000.00

Weight
35%
4%
61%
100%

$
$
$
$

Market
Value
Weight
20,461,993.13
46%
2,400,000.00
5%
21,850,000.00
49%
44,711,993.13
100%

Target
Weights
35%
5%
60%
100%

Comments:
3
The Book value of the Capital structure is very close to the target weights, being right on for debt and off by
just one point under for preferred and one point over for equity, while the Market value is just slightly higher for
both debt and equity and right on for preferred stock.
Total
21

Cost of Capital: Weighted Average Cost of Capital TAB

points
B

Calculate the cost of debt based on the market return on the company's existing bonds.
Cost
of
Debt
2.600%

=
=

Market
yield
(kd)
0.04

( 1 -

( 1 -

Tax
Rate
(T)
0.35

)
)

Calculate the cost of preferred stock based on the market return on the company's existing preferred stock
Cost of
Preferred
Stock
5.618%

=
=

Market
Rate
(Kp)
0.05

( 1 -

( 1 -

Floatation
Rate
(f)
0.11

)
)

Calculate the cost of retained earnings using three approaches, CAPM, dividend growth, and risk premium. Reconcile the results into a single estimate
CAPM:
Cost of
Retained
Earnings
7.900%

=
=

Risk Free
Rate
(krf)
0.025

Market
Return
(km)
0.085

Risk Free
Rate
(krf)
0.025

) X
) X

beta
(bx)
0.9

Dividend Growth:
Cost of
Retained
Earnings
7.578%

Latest
Dividend X ( 1 +
(D0)
0.5 X ( 1 +

Growth
Rate
g
0.03

) /
) /

Stock
Price
P0
11.25

)+
)+

Growth
Rate
g
0.03

Risk Premium:
Cost of
Retained
Earnings
7.000%

=
=

Bond
Yield
kd
0.04

+
+

Risk
Premium
rpe
0.03

Reconciliation
7.493%

2
E

Estimate the cost of equity raised through the sale of new stock using the dividend growth approach
Cost of New
Common
Stock
8.144%

Latest
Dividend
(D0)
$
0.50

X ( 1+
X ( 1+

Growth
Rate
)) / (
g
0.03 ) ) / (

(1(1-

Floatation
Rate
(f)
0.11

Calculate the WACC using equity from retained earnings based on your component cost estimates and the target capital structure

Debt
Preferred
Common Equity

6
3

Target
Weights
35%
5%
60%

Cost

WACC

Total
23

Factors

2.600% 0.9100%
5.618% 0.2809%
7.493% 4.4956%
5.7%

)X
)X

Stock
Price
P0
$ 11.25

)+
)+

Growth
Rate
g
0.03

Capital Rationing: Calculating Breakpoints TAB

points
g Where is the first breakpoint in the MCC (the point where retained earnings runs out)? Calculate to the nearest $.1M.
Dividends:

Common
Dividends
1,150,000.00

=
=

Dividend
per share
$

Preferred
Dividends
10,000.00

=
=

Dividend
per share
$

Retained
Earnings
3,840,000.00

=
=

Breakpoint
6,400,000.00

=
=

0.50

X
X

Common
Stock issued
2,300,000.00

0.50

X
X

Preferred
Stock issued
20,000

Earnings
$ 5,000,000.00

Retained
Earnings
3,840,000.00

Total
Dividends
$ 1,160,000.00
Target
Weight
60%

/
/

h Calculate the WACC after the first breakpoint.

Target
Weights
Debt
Preferred
Equity

Cost
35%
5%
60%

Factors

2.60%
5.62%
8.14%

0.91%
0.28%
4.89%

6.08%
i Where is the second breakpoint in the MCC (the point at which the cost of debt increases.)

Breakpoint
$10,000,000.00

=
=

Additional
Lending Available
$3,500,000

Target
Weight
35%

/
/

j Calculate the WACC after the second break. Calculate to the nearest 0.1%.
Target
Weights

6
3

Total
21

Debt
Preferred
Equity

Cost
35%
5%
60%

4.55%
5.62%
8.14%

Factors
1.59%
0.28%
4.89%
6.76%

MCC - IOS Plot TAB

points
10
10

k Plot Gustafson's MCC.

l Plot Gustafson's IOS on the same axes as the MCC.

16%

Gustafson Marginal Cost of Capital and Investment Opportunity Schedule

14%
A
12%

10%

8%
B

Cost of
Capital

6%
C
D

4%

2%

$2M

Total
20

$4M

$6M
Total Capital Raised

$8M

$10M

$12M

Capital Planning TAB

points

m Which projects should be accepted and which should be rejected?

We should accept project A & B and reject project C & D

5
n Do any of those rejected have IRRs above the initial WACC? Which ones?
Yes, C
5

o If so, explain in words why they're being rejected.

We are rejecting project C even though it has an IRR above the initial WACC
because WACC after the first breakpoint is above the IRR of this project.
5

Total
15