Medical Research Corporation has been expanding its production capacity and rese
ID: 2754317 • Letter: M
Question
Medical Research Corporation has been expanding its production capacity and research to introduce a new product line. Current plans call for spending $ 100 million in four projects of the same magnitude ($ 25 million each), but offer different performance. Project A is on proteins for blood clotting and has an expected return of 18%. Project B is related to a vaccine for hepatitis and includes an expected return of 14%. The C project, which is a cardiovascular compound, has expectations to win 11.8%, and D project, an investment of orthopedic implants, has the expectation of showing a 10.9% yield.
The company has $ 15 million in retained earnings. After a capital structure is reached with $ 15 million in retained earnings (in which the retained earnings account for 60% of funding), any additional equity financing should be channeled in the form of new common capital.
The common stock sold at a price of $ 25 per share and insurance costs have been estimated at $ 3 if the new shares are issued. The dividends for the following year will be $ 0.90 per share (D), and profits and dividends have consistently grown 11% per year.
The comparative performance of bonds has been hovering around 11%. The investment banker feels that the first $ 20 million of bonds could be sold so that changeover yield 11% while the additional debt may require a premium of 2% and sold so that changeover yield 13%. The corporate tax rate is 30%. The debt represents 40% of the capital structure.
c. What will be the marginal cost of the capital immediately after that point?
Explanation / Answer
Answer:c
Solution:
Marginal Cost of
Capital and Investment Returns
Medical Research Corporation
a. Kd = Yield (1 – T)
= 11% (1 – .30) = 11% (.70) = 7.70%
Ke = (D1/Po) + g
= ($.90/$25.00) + 11.0% = 3.6% + 11.0% = 14.60%
Cost
(aftertax)
Weights
Weighted
Cost
Debt (Kd)........................................
Common equity (Ke)
(retained earnings).......................
Weighted average cost
of capital (Ka)...............................
7.70%
14.60
40%
60
3.08%
8.76
11.84%
X=Retained earnings/% of retained earnings in the capital structure
=$15 million/0.50=$25 million
First compute Kn
Kn = (D1/(Po – F)) + g
= ($.90/($25 – $3)) + 11%
= ($.90/$22) + 11% = 4.09% + 11% = 15.09%
Cost
(aftertax)
Weights
Weighted
Cost
Debt (Kd)........................................
New common stock
(Kn)...............................................
Marginal cost of capital
(Kmc).............................................
7.70%
15.09
40%
60
3.08%
9.05
12.13%
Solution:
Marginal Cost of
Capital and Investment Returns
Medical Research Corporation
a. Kd = Yield (1 – T)
= 11% (1 – .30) = 11% (.70) = 7.70%
Ke = (D1/Po) + g
= ($.90/$25.00) + 11.0% = 3.6% + 11.0% = 14.60%
Cost
(aftertax)
Weights
Weighted
Cost
Debt (Kd)........................................
Common equity (Ke)
(retained earnings).......................
Weighted average cost
of capital (Ka)...............................
7.70%
14.60
40%
60
3.08%
8.76
11.84%
X=Retained earnings/% of retained earnings in the capital structure
=$15 million/0.50=$25 million
First compute Kn
Kn = (D1/(Po – F)) + g
= ($.90/($25 – $3)) + 11%
= ($.90/$22) + 11% = 4.09% + 11% = 15.09%
Cost
(aftertax)
Weights
Weighted
Cost
Debt (Kd)........................................
New common stock
(Kn)...............................................
Marginal cost of capital
(Kmc).............................................
7.70%
15.09
40%
60
3.08%
9.05
12.13%