Question

On January 1, the total market value of the Tysseland Company was $60 million. During the year, the company plans to raise and invest $30 million in new projects. The firm's present market value capital structure, shown below, is considered to be optimal. Assume that there is no short-term debt.
Debt $30,000,000
Common equity 30,000,000
Total capital $60,000,000
New bonds will have an 10% coupon rate, and they will be sold at par. Common stock is currently selling at $30 a share. The stockholders' required rate of return is estimated to be 12%, consisting of a dividend yield of 4% and an expected constant growth rate of 8%. (The next expected dividend is $1.20, so $1.20/$30 = 4%). The marginal corporate tax rate is 30%. In order to maintain the present capital structure, how much of the new investment must be financed by common equity?
Assuming there is sufficient cash flow such that Tysseland can maintain its target capital structure without issuing additional shares of equity, what is its WACC?
Suppose now that there is not enough internal cash flow and the firm must issue new shares of stock. Qualitatively speaking, what will happen to the WACC?
I. rs and the WACC will increase due to the flotation costs of new equity.
II. rs and the WACC will decrease due to the flotation costs of new equity.
III. rs will increase and the WACC will decrease due to the flotation costs of new equity.
IV. rs will decrease and the WACC will increase due to the flotation costs of new equity.
V. rs and the WACC will not be affected by flotation costs of new equity.

Answer 1

Answer:

Tysseland Company

1.  In order to maintain the present capital structure, the new investment must be financed by common equity to the tune of $15 million (50% of $30 million).

2. Assuming there is sufficient cash flow such that Tysseland can maintain its target capital structure without issuing additional shares of equity, its WACC = 9.5%

3. IV. rs will decrease and the WACC will increase due to the flotation costs of new equity.

Explanation:

a) Data and Calculations:

Total market capitalization = $60 million

                                     Debt          Common Equity     Total

Market value          $30,000,000   $30,000,000    $60,000,000

Weight                          50%                  50%                 100%

New financing          15,000,000      15,000,000       30,000,000

New market cap.  $45,000,000   $45,000,000     $90,000,000

Coupon rate of new bonds issued at par = 10%

Selling price of common stock = $30 per share

Stock's required rate of return = 12%

Estimated Dividend yield = 4%

Expected constant growth rate = 8%

Expected dividend per share = $1.20 ($30 * 4%)

Corporate tax rate = 30%

Cost of Equity = the stockholders' required rate of return = 12% or

= (Dividend/Price) + g (growth rate)

= ($1.20/$30) + 0.08

= 12%

After-Tax Cost of Debt = Before Tax Cost of Debt × (1-Tax Rate)

10 × (1 - 0.3)= 7%

WACC = (Weight of Equity × Cost of Equity) + (Weight of Debt × After Tax Cost of Debt)

(0.5 × 12%) + (0.5 × 7%) = 9.5%