Lancaster Engineering Inc.

(LEI) has the following capital structure, which

Lancaster Engineering Inc. (LEI) has the following capital structure, which it considers to be optimal:
Debt . 25%
Preferred stock . 15
Common equity 60
100%
LEIs expected net income this year is $34,285.72; its established dividend payout ratio is 30 percent; its marginal
tax rate is 30 percent; and investors expect earnings and dividends to grow at a constant rate of 9 percent in the
future. LEI paid a dividend of $3.60 per share last year, and its stock currently sells at a price of $60 per share.
LEI can obtain new capital in the following ways:
Common stock: New common stock has a flotation cost of 10 percent for up to $12,000 of new stock and 20 percent
for all common stock over $12,000. Preferred stock: New preferred stock with a dividend of $11 can be sold to the
public at a price of $100 per share, however, flotation costs of $5 per share will be incurred for up to $7,500 of
preferred stock, and flotation costs will rise to $10 per share, or 10 percent, on all preferred stock over $7,500. Debt:
Up to $5,000 of debt can be sold at an interest rate of 12 percent; debt in the range of $5,001 to $10,000 must carry
an interest rate of 14 percent; and all debt over $10,000 will have an interest rate of 16 percent.
LEI has the following independent investment opportunities:

a. Find the break points in the MCC schedule.

b. Determine the cost of each capital structure component.
c. Calculate the WACC in the interval between each break in the MCC schedule.
d. Calculate the expected return for Project E.
e. Construct a graph showing the MCC and IOS schedules.
f. Which projects should LEI accept?
Solutions:

Retained Earnings after tax= 34,285.72X(1-.3) = Tk. 24,000

Break Points for Retained Earnings = 24,000/0.6 = 14,400
Cost of Retained Earnings (ROE) = g/(1-pay-out ratio) = .09/.7 =12.8%
Break Points for common stock = 12,000/0.6 = 20,000
Cost of common stock for upto 12,000 new stocks = {3.60/(60-60X10%)} + 0.09 = 15.6%
Cost of common stock for over 12,000 new stocks = {3.60/(60-60X20%)} + 0.09 = 16.5%
Break Points for Preferred stocks= 7500/.15 = 50,000
Cost of Pref. stock upto 7,500 = 11/(100-5) = 11.6%
Cost of Pref. stock over 7,500 = 11/(100-10) = 12.2%
Break Points for Debts = 5,000/.25 = 20,000
Break Points for Debts = 10,000/.25 = 40,000
Cost of debts upto 5000 debts = 12%X(1-.3) = 8.4%
Cost of debts between 5000 and 10000 debts = 14%X(1-.3) = 9.8%
Cost of debts Over 10000 debts = 16%X(1-.3) = 11.2%

The Break points are 14,400; 20,000; 40,000; 50,000

WACC in Break Points:

Range Source of Capital % of Capital Cost of Capital Weighted

0-14400 Retained Earnings .60 12.8% 7.68%

Overall cost of capital 7.68%
14401-20000 Debt .25 8.4% 2.1%
Common Stock .60 15.6% 9.36%
Overall cost of capital 11.46%
20001-40000 Debt .25 9.8% 2.1%
Common Stock .60 16.5% 9.9%
Overall cost of capital 12.0%
40001-50000 Debt .25 11.2% 2.8%
Pref. Stock .15 11.6% 1.74%
Common Stock .60 16.5% 9.9%
Overall cost of capital 14.44%
50000+ Debt .25 11.2% 2.8%
Pref. Stock .15 12.2% 1.83%
Common Stock .60 16.5% 9.9%
Overall cost of capital 14.53%

Considering Cost of capital at 20%, the NPV = 5427.84 X PVIFA20%,6 20,000

= 5427.84X 3.3255 20,000 = -1949.72

Considering Cost of capital at 10%, the NPV = 5427.84 X PVIFA10%,6 20,000

= 5427.84X 4.3553 20,000 = 3639.87

By using interpolation technique,

IRR for Project E = 10% + {(3639.87 X 10%)/(3639.87+1949.72)} = 10% + 6.5% = 16.5%

Since Project B has the highest return, so the project B can be accepted.