Miller Engine Research is expanding its research and production capacity to intr
ID: 2666152 • Letter: M
Question
Miller Engine Research is expanding its research and production capacity to introduce a new line of fuel technology for car engines. Current plants call for the expenditure of $100 million on four projects of equal size, but different returns. Project I is in a hybrid solar cell technology and has an expected return of 16 per cent. Project II relates to biofuel production and carries a potential return of 12.5 per cent. Project III dealing with a photocatalyst compound, is expected to earn 11.2 per cent, and Project IV, an investment in liquid nitrogen storage system, is expected to generate a 10.2 per cent return per annum.The firm has $15 million in retained earnings. After a capital structure with $15 million in retained earnings is reached (in which retained earnings represents 60 per cent of the financing), all additional equity financing must come in the form of new common stock. Common stock is selling for $24 per share and underwriting costs are estimated at $3 if new shares are issued. Dividends for the next year will be $0.80 per share (D1), and earnings and dividends have grown consistently at 11 per cent per year. The yield on comparative bonds has been hovering at 12 per cent. The investment bankers feels that the first $20 million of bonds could be sold to yield 12 per cent and any additional debt might require a 2 per cent premium and be sold to yield 14 per cent. The corporate tax rate is 30 per cent. Debt represents 40 per cent of the capital structure.
a. Based on the two sources of financing, what is the initial weighted average cost of capital (Kd and KE).
b. At what size capital structure will the firm run out of retained earnings? What will the marginal cost of capital be immediately after that point?
c. At what size capital structure will there be a change in the cost of debt? What will the marginal cost of capital be immediately after that point?
d. Determine the size of capital investment the firm should adopt.
Explanation / Answer
Cost of retained Earnings =( D1/ Price of common stock ) + Future growth rate = (.80/ 24 )+11% = 3.3%+11% = 14.3% Cost of new common equity = [D1/ P0*(1-Floatation cost)]+ G =.80/24*(1-12.5%)+11% = (.80/ 24*0.875)+11% =(0.80/21)+11% =3.81%+11% =14.81% cost of Debt = 14%(since value Above 20million = 85million*.40 =34 million) Interest *(1-Tc) Up to 20 million cost of debt = 12% Cost = 20million *12% = 2.4Millions 20to 34 milllion = 14*14% =1.96Millions cost of debt = 2.4+1.96 = 4.36 million = 4.36/ 40miilions = 10.9% Here weights are Reatined Earnings = 15 million = 15/100 = 15% And debt shoud be 40% remain would be weight of equity = [100-15-40 = 45%]. a) Based on the two sources of financing, what is the initial weighted average cost of capital (Kd and KE). Ke= We*rE+Wd*rd(1-Tc)+Wre*rRE(retained earnings) = 0.45*14.81%+0.40*10.9%(0.7)+0.15*14.3% =11.86% =11.86% b) b. At what size capital structure will the firm run out of retained earnings? What will the marginal cost of capital be immediately after that point?If ignore the retained earning then the cost of captal ,but this portion repalce with equity so the equity weight = .45+.15 = .60 = 0.60*14.81% + 0.40 * 10.9%(1-0.30) = 10.19% Marginal cost of capital = 11.86% - 10.19% =1.66% c) . At what size capital structure will there be a change in the cost of debt? What will the marginal cost of capital be immediately after that point?
If debt portion replaced the reained earnings then, = 0.45*14.81%(For Equity) And debt Potion has to be caliculate separatly ... up to 20 million cost of debt = 12% = 20million *12% 2.4Million Beyond that 14% = 45millions * 14% = 6.3Millions Total cost of debt = 2.4+6.3 = 8.7Millions Cost of Debt % = 8.7/ 65 Millions = 13.38% Weighted Avg Cost of capital = We*rE+Wd*rD(1-Tc) Debt Weigt = .4+0.15 = 0.65 =0.45*14.81% + 0.65*13.38%(1-0.30) = 12.75% Here marginal cost of capital = 11.86%-12.75% = 0.89%(negative) d)Size of capital investmetn Projects 1 2 3 4 Individual Expected return 16% 12.50% 11.20% 10.20% Weights 0.25 0.25 0.25 0.25 Total Expected return 0.04 0.03125 0.028 0.0255 Total 0.12475 = 12.48% is required return ,so the managent Should be designe capital structure below of this size. So it is better repalce with eqity that is 10.19%
Projects 1 2 3 4 Individual Expected return 16% 12.50% 11.20% 10.20% Weights 0.25 0.25 0.25 0.25 Total Expected return 0.04 0.03125 0.028 0.0255 Total 0.12475