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A Problem Introduction Tab This financial plannin

g

pro

j

ect is split into several parts E

ach section has its own tab. Section Problem Introduction TA

B This tab

Gustafson Financial Inform

at

ion

TAB

You will find all the given data here 1 C

ost

of

Capital : Capital Structure TAB This section is split into two tabs:

Cost

of Capital

A and

Cost of

Capital B Cost of Capital

A concentrates on the developing Gustafson Capital Structure Problem: a

) Calculate the firm’s capital structure based on boo

k

and market values and compare

with

the target capital structure.

2

Cost of Capital:

WACC

TAB Cost of Capital B concentrates on calculating Gustafson’s WACC b) Calculate the cost of debt based on the market return on the company’s e

x

isting

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

3

Capital Rationing

: Finding the Break

points

TAB

This section calculate the breakpoints 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.) j) Calculate the WACC after the second break. Calculate to the nearest $0.1M. 4

MCC

–

IOS Plot

TAB

In this section we plot the Marginal Cost of Capital and the

Investment Opportunity Schedule This tab MCC-IOS is to be used as a template for your graphs Use the Commands Insert>line and Insert>rectangle to create your plot k) Plot Gustafson’s Marginal Cost of Capital. l) Plot Gustafson’s IOS on the same axes as the MCC. 5

Capital Plan

ning TAB

In this section, we analyze our data and make our conclusions m) Which projects should be accepted and which should be rejected? n) D

o any of those rejected have

IRR

s above the initial WACC? Which ones? o) If so, explain in words why they’re being rejected. p) What is the WACC for the planning period? Answers are to be entered in the black outlined, yellow boxes Supporting data is to be entered in the underlined yellow boxes. Enter all percentages as decimals

Gustafson Financial Information

bonds

at

with

issued

,000

years ago

at

par value

5%

issued

Capital Structure

Debt

Preferred 5%
Equity

Financial Information

35%

coasts average

s

return is

is

$ 5,000,000.00

Investment Opportunity Schedule

IRR

A

B

C

D 5%

Gustafson Gutters Financial Data
						Debt
		issued	18,000	30	year			10		years ago
$ 1,000.00		par value								5%	coupon rate
similar bonds now selling at
	4%
									Preferred				Stock
	20	shares				6
$ 100.00
with dividend of	$6
similar preferred issues are now selling at
						Equity
2,300,000	shares at	$ 9.50
Accumulated retained earning is now		$ 5,000,000.00
stock closed at	$ 11.25
Torborg’s						Target
					35%
				60%
	Additional
Marginal	Tax								Rate
		Floatation	11%	for both common and preferred stock
Short Term Treasury	yield	2.5%
				Market	8.5%
Gustafson	beta	0.9
Indefinite expected growth:	3%
Last annual dividend	$ 0.50			per share
Expected next years’ earnings
Firm can borrow up to	$ 1,500,000.00	at market return of old debt
lenders will demand	7%	for borrowing beyond
Project	Capital Requirement
	14%	$ 3,000,000.00
	8%	$ 2,500,000.00
	6%	$ 2,000,000.00
$ 1,000,000.00

Cost of Capital Capital Structu

A

s

d

2

Value

of Debt = (

X

x

Number of Bonds Issued

2 = ( X + x ) X
Preferred Stock = Face Value X

2 = X

tuity (Dp/k)

Preferred

Preferred Stock = (

(Dp)

/

(k)

) X Stock Issued

2 = ( / ) X
Book Value of

Issue

Equity = (

X

) +

2 = ( X ) +
Market Value of Common Market Retained

Equity = ( Stock issued X Price ) + Earnings
2 = ( X ) +

Cost of Capital

Book Market Target
Value

Value Weight

Debt 35%
Preferred 5%
Equity 60%
6

3

Cost of Capital: Capital Structure TAB

score

Calculate the firm’s capital structure based on book and market values and compare with the target capital structure.

Debt:

Book

Value

of Debt

Number of

Bond

Issue

Bond

Face Value

=

X

Market

PMT

PVFA(k,n)

+

FV

PVF(k,n)

) X

k =

n =

Preferred:

Book Value of

Preferred Stock

Preferred

Stock Issued

PV of a Pe

rpe

Market Value of

Dividend

Market

Rate

Equity:

Common

Retained

Stock issued

Price

Earnings

Part 1

page 2

Capital Structure Comparison:

Weight

Weights

total

100%

Comments:

Total

21

Cost of Capital WACC

points
B

Cost Market Tax
of = yield X

Rate )

Debt

)

2 = X ( 1 – )
C Calculate the cost of preferred stock based on the market return on the company’s existing preferred stock
Cost of Market Floatation
Preferred = Rate / ( 1 – Rate )
Stock

2 = / ( 1 – )
D

Cost of

Free

Market Risk Free

Retained = Rate + (

– Rate

beta

Earnings

(krf)

2 = + ( ) X

:

Cost of

Growth Stock Growth

Retained = ( Dividend

Rate

Price

Rate

Earnings

g

g

2 = ( X ( 1 + ) / ) +

:

Cost of Bond Risk
Retained =

+ Premium

Earnings kd rpe
2 = +
2
E Estimate the cost of equity raised through the sale of new stock using the dividend growth approach

Latest Growth Floatation Stock Growth

Common = ( Dividend X ( 1 + Rate

Rate

Price ) + Rate

Stock (D0) g (f) P0 g
2 = ( X ( 1 +

( 1 – ) X ) +

F Calculate the WACC using equity from retained earnings based on your component cost estimates and the target capital structure
Target Cost

Weights
Debt 35%
Preferred 5%
6

60%

3 WACC

Total

Cost of Capital: Weighted Average Cost of Capital TAB
Calculate the cost of debt based on the market return on the company’s existing bonds.
			( 1 –
(	kd	(T)
(Kp)		(f)
Calculate the cost of retained earnings using three approaches, CAPM, dividend growth, and risk premium. Reconcile the results into a single estimate
CAPM:
		Risk
Return		) X
	(krf)	(km)	(bx)
Dividend				Growth
	Latest
			X ( 1 +		) /				) +
	(D0)		P0
Risk	Premium
Yield
Reconciliation
Cost of New
) ) / (		( 1 –		) X
) ) / (
		Factors
Common Equity
23

Capital Rationing

s TAB

points

g

:

Common Dividend Common
Dividends = per share X Stock issued
2 = X
Preferred Dividend Preferred

Dividends = per share X Stock issued
2 = X

Retained

Earnings = Earnings – Dividends
2 = –
Retained Target
Breakpoint = Earnings / Weight
2 = /
h Calculate the WACC after the first breakpoint.

Target Cost Factors
Weights

Debt 35%
Preferred 5%
Equity 60%
2
i Where is the second breakpoint in the MCC (the point at which the cost of debt increases.)
Additional Target
Breakpoint =

/ Weight

2 = /

j

Target Cost Factors
Weights
Debt 35%
Preferred 5%

6 Equity 60%
3

Total
21

Capital Rationing: Calculating		Breakpoint
Where is the first breakpoint in the MCC (the point where retained earnings runs out)? Calculate to the nearest $.1M.
			Dividends
Total
Lending Available
Calculate the WACC after the second break. Calculate to the nearest 0.1%.

MCC – IOS Plot

points

10 k

10 l Plot Gustafson’s IOS on the same axes as the MCC.
14%
8%
Cost of Capital 6%

4%

2%

Total

20

	MCC – IOS Plot TAB
Plot Gustafson’s MCC.
16%	Gustafson Marginal Cost of Capital and Investment Opportunity Schedule
1	2%
10%
$2M	$4M	$6M	$8M	$10M	$12M
Total Capital Raised

Capital Plan

points

m Which projects should be accepted and which should be rejected?
5
n

5

o If so, explain in words why they’re being rejected.

5

Total

	Capital Planning TAB
Do any of those rejected have IRRs above the initial WACC? Which ones?
15