Question 4 Acme Publishing has the following (independent) investment opportunities: Project Initial investment IRR A $13 000 16% B $17 000 14% C $10 000 10% The optimal capital structure...

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Finance

Question 4
Acme Publishing has the following (independent) investmentopportunities:
Project
Initial investment
IRR
A
$13 000
16%
B
$17 000
14%
C
$10 000
10%
The optimal capital structure calls for financing all projectswith 60 per cent ordinary shares and 40 per cent debt. Thefollowing information applies to the future financial position ofAcme Publishing:
The most recent dividend (DO) was $0.35
The growth rate of earnings and dividends is 6 per cent
The current price of shares is $4.60
If new shares are issued, a flotation cost of 10% will beincurred
The company can borrow up to $10,000 from its bank at aninterest rate of 12%. For any amount of debt above $10,000, theinterest rate is 14%
The company’s dividend pay out ratio is 40%
The company is in a 30% tax bracket
Acme Publishing earned $35,000 last year before tax
Required
In which of the projects (if any) should Acme Publishing invest,and what is its capital budget and weighted average cost of capital(WACC)?

Answer & Explanation Solved by verified expert

4.0 Ratings (711 Votes)

After tax earning- last year = 35000*(1-.4)		21000
% of debt in total capital structure = 40000*40%		16000
Interest on debt value 0f 16000	(1000012%)+(600014%)	2040
interest payent as % of total debt borrowed	2040/16000	12.75%
after tax cost of debt = interest rate*(1- tax rate)	12.75*(1-.4)	7.65
cost of common share new issue =(expected dividend/marke price less flotation cost)+ growth rate	(.371/4.14)+6%	14.96%
expected dividend = current year dividend*(1+growth rate)	.35*1.06	0.371
market price less flotation cost	4.6-(4.6*10%)	4.14

cost of common share - equity =(expected dividend/marke price )+ growth rate	(.371/4.6)+6%	14.07%
expected dividend	.35*1.06	0.371
market price	4.6	4.6

WACC
Source	value of investment	Weight	component cost	weight*component cost
bank loan	16000	0.4	7.65	3.06
common stock-equity	21000	0.525	14.07	7.38675
common stock-new stock	3000	0.075	14.96	1.122
total optimal capital structure	40000			11.57


Project	IRR	WACC	Accept = IRR>WACC reject IRR	Initial Investment
A	16%	11.57%	Accept	13000
B	14%	11.57%	Accept	17000
C	10%	11.57%	reject	10000
total capital budget				30000

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Transcribed Image Text

Question 4Acme Publishing has the following (independent) investmentopportunities:ProjectInitial investmentIRRA$13 00016%B$17 00014%C$10 00010%The optimal capital structure calls for financing all projectswith 60 per cent ordinary shares and 40 per cent debt. Thefollowing information applies to the future financial position ofAcme Publishing:The most recent dividend (DO) was $0.35The growth rate of earnings and dividends is 6 per centThe current price of shares is $4.60If new shares are issued, a flotation cost of 10% will beincurredThe company can borrow up to $10,000 from its bank at aninterest rate of 12%. For any amount of debt above $10,000, theinterest rate is 14%The company’s dividend pay out ratio is 40%The company is in a 30% tax bracketAcme Publishing earned $35,000 last year before taxRequiredIn which of the projects (if any) should Acme Publishing invest,and what is its capital budget and weighted average cost of capital(WACC)?

Project	Initial investment	IRR
A	$13 000	16%
B	$17 000	14%
C	$10 000	10%