Accounting quiz

Question # 00002225 Posted By: mac123 Updated on: 10/12/2013 05:16 PM Due on: 10/14/2013
Subject Accounting Topic Accounting Tutorials:
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Hammell Industries has been using 10% as its cost of retained earnings for a number of years. Management has decided to revisit this decision based on recent changes in financial markets. An average stock is currently earning 8%, treasury bills yield 3.5%, and shares of Hammell’s stock are selling for $29.44. The firm just paid a dividend of $1.50, and anticipates growing at 5% for the foreseeable future. Hammell’s CFO recently asked an investment banker about issuing bonds and was told the market was demanding a 6.5% coupon rate on similar issues. Hammell stock has a beta of 1.4. Recommend a cost of retained earnings for Hammell.


MCC: Example 13-9 (page 573)

. Whitley Motors Inc. has the following capital.

Debt: The firm issued 900, 25 year bonds five years ago which were sold at a par value of $1,000. The bonds carry a coupon rate of 7%, but are currently selling to yield new buyers 10%.

PreferredStock:3,500 shares of 8% preferred were sold 12 years ago at a par value of $50. They’re now priced to yield 11%.

Equity: The firm got started with the sale of 10,000 shares of common stock at $100 per share. Since that time earnings of $800,000 have been retained. The stock is now selling for $89. Whitley’s business plan for next year projects net income of $300,000, half of which will be retained.

The firm’s marginal tax rate is 38% including federal and state obligations. It pays flotation costs of 8% on all new stock issues. Whitely is expected to grow at a rate of 3.5% indefinitely and recently paid an annual dividend of $4.00.

Develop Whitley’s WACC before and after the retained earnings break and indicate how much capital will have been raised when the break occurs.


The Longenes Company uses a target capital structure when calculating the cost of capital. The target structure and current component costs based on market conditions follow.

Component Mix Cost*

Debt 25% 8%

Preferred Stock 10% 12%

Common Equity 65% 20%

*The costs of debt and preferred stock are already adjusted for taxes and/or flotation costs. The cost of equity is unadjusted.

The firm expects to earn $20 million next year, and plans to invest $18 million in new capital projects. It generally pays dividends equal to 60% of earnings. Flotation costs are 10% for common and preferred stock.

a. What is Longenes’ initial WACC?

b. Where is the retained earnings breakpoint in the MCC? (Round to the nearest $.1M.)

c. What is the new WACC after the break? (Adjust the entire cost of retained earnings for flotation costs.)

d. Longenes can borrow up to $4 million at a net cost of 8% as shown. After that the net cost of debt rises to 12%. What is the new WACC after the increase in the cost of debt?

e. Where is the second break in the MCC? That is, how much total capital has been raised when the second increase in WACC occurs?

f. Sketch Longenes’ MCC.


Cost of Capital Comprehensive Problem and IOS: Example 13-10 (page 576) and Combining the MCC and the IOS (page 575)

25. Taunton Construction Inc.'s capital situation is described as follows:

Debt: The firm issued 10,000 25-year bonds10 years ago at their par value of $1,000. The bonds carry a coupon rate of 14% and are now selling to yield 10%.

Preferred Stock:30,000 shares of preferred stock were sold six years ago at a par value of $50. The shares pay a dividend of $6 per year. Similar preferred issues are now yielding 9%.

Equity: Taunton was initially financed by selling 2 million shares of common stock at $12. Accumulated retained earnings are now $5 million. The stock is currently selling at $13.25.

Taunton'sTarget Capital Structureis as follows:

Debt 30.0%

Preferred Stock 5.0%

Common Equity 65.0%


Other information:


Taunton's marginal tax rate (state and federal) is 40%.


Flotation costs average 12% for common and preferred stock.


Short-term treasury bills currently yield 7.5%.


The market is returning 12.5%.


Taunton's beta is 1.2.


The firm is expected to grow at 6% indefinitely.


The last annual dividend paid was $1.00 per share.


Tauntonexpects to earn $5 million next year.


The firm can borrow an additional $2 million at rates similar to the market return on its old debt. Beyond that lenders are expected to demand returns in the neighborhood of 14%.


Tauntonhas the following capital budgeting projects under consideration in the coming year. These represent its investment opportunity schedule (IOS).

Capital Cumulative

Project IRR Required Cap. Req.

A 15.0% $3M $3M

B 14.0% $2M $5M

C 13.0% $2M $7M

D 12.0% $2M $9M

E 11.0% $2M $11M

a. Calculate the firm's capital structure based on book and market values and compare with the target capital structure. Is the target structure a reasonable approximation of the market value based structure? Is the book structure very far off?

b. Calculate the cost of debt based on the market return on the company's existing bonds.

c. Calculate the cost of preferred stock based on the market return on the company's existing preferred stock.

d. Calculate the cost of retained earnings using three approaches, CAPM, dividend growth, and risk premium. Reconcile the results into a single estimate.

e. Estimate the cost of equity raised through the sale of new stock using the dividend growth approach.

f. Calculate the WACC using equity from retained earnings based on your component cost estimates and the target capital structure.

g. Where is the first breakpoint in the MCC (the point where retained earnings runs out)? Calculate to the nearest $.1M.

h. Calculate the WACC after the first breakpoint.

i. Where is the second breakpoint in the MCC (the point at which the cost of debt increases.) Why does this second break exist? Calculate to the nearest $.1M.

j. Calculate the WACC after the second break.

k. Plot Taunton's MCC.

l. Plot Taunton's IOS on the same axes as the MCC. Which projects should be accepted and which should be rejected? Do any of those rejected have IRRs above the initial WACC? If so, explain in words why they're being rejected.

m. What istheWACC for the planning period?

n. Suppose project E is self-funding in that it comes with a source of its own debt financing. A loan is offered through an equipment manufacturer at 9%. The cost of the loan is 9%´(1-T) = 5.4%.

Should project E be accepted under such conditions?


Newrock Manufacturing Inc. has the following target capital structure

Debt 25%,

preferred 20%

equity 55%

Investment bankers have advised the CFO that the company could raise up to $5 million in new debt financing by issuing bonds at a 6.0% coupon rate, beyond that amount new debt would require a 7% coupon. Newrock’s 8.5% preferred stock, issued at a par value of $100, currently sells for $112.50. There are 3,000,000 shares of common stock outstanding on which the firm paid an annual dividend of $2.00 recently. The stock currently trades at $36 per share. Next year’s net income is projected at $14,000,000 and management expects 6% growth in the foreseeable future. Floatation costs are 6% on debt and 11% on common and preferred stock. The marginal tax rate is 40%.

a. Calculate the WACC using the target capital structure and the cost of retained earnings for the equity component.

b. Plot Newrock’s MCC identifying the levels of funding at which the first two breaks occur, and calculate the WACCs after each break.

c. Newrock has identified the following capital projects for next year:

Project Investment IRR

A $ 4.0 million 11.0%

B $ 3.6 million 10.5%

C $ 8.6 million 13.2%

D $ 2.0 million 8.7%

E $ 5.5 million 9.5%

F $ 5.0 million 7.2%

G $ 4.1 million 10.5%

H $ 6.4 million 8.0%

Projects A and B are mutually exclusive, as are Projects C and H. Plot the IOS and the MCC and determine the ideal size of next year’s capital program.

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