Medical Research Corporation has been expanding its production capacity and rese
ID: 2754322 • 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.
g. Let's plot the response given in Part f.
Explanation / Answer
$ in millions Investment requried 100 Retained earnings 15 Common stock price 25 per share insurance cost $3 per new share D1(dividend) $0.90 Growth rate 11% First 20 million bond 11% rest bond 13% Corporate tax 30% Capital structure Ke = D1 / P0 + g P0 = ex-dividend equity value today. D1 = expected future dividend at Time 1 period later. Ke = cost of equity per period. g = constant periodic rate of growth in dividend from Time 1 to infinity. Ke = .90/25+11% 14.60% Cost of debt: weights first 20 million 0.11 0.5 5.5% next 20 million 0.13 0.5 6.5% Weighted cost of debt pre tax 12.0% Tax rate 30% Post tax cost of debt 8.40% value Weight Cost weight*cost Retained earnings 15 Common stock 45 Total Equity 60 0.6 14.60% 8.76% Debt 60 0.4 8.40% 3.36% Weighted average cost of capital 12.12% Project A Project B Project C Project D Initial outflow 25 25 25 25 Expected return 14% 14% 11.80% 10.90% weights 25% 25% 25% 25% Expected return*weights 0.035 0.035 0.0295 0.02725 Total expected return 12.68%