FN300 Finance LOA

Problem Introduction Tab

This financial planning project is split into several parts
Each section has its own tab.
Section
Problem Introduction TAB
This tab

Gustafson Financial Information TAB

You will find all the given data here

1 Cost 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 book 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 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

3 Capital Rationing: Finding the Breakpoints 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 Planning TAB

In this section, we analyze our data and make our conclusions
m) Which projects should be accepted and which should be rejected?
n) Do any of those rejected have IRRs 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 Gutters Financial Data

Debt

issued 18,000 30 year bonds 10 years ago

at $ 1,000.00 par value with 5% coupon rate
similar bonds now selling at 4%

Preferred Stock
issued 20,000 shares 6 years ago
at $ 100.00 par value
with dividend of $6
similar preferred issues are now selling at 5%

Equity
issued 2,300,000 shares at $ 9.50
Accumulated retained earning is no $ 5,000,000.00
stock closed at $ 11.25

Torborg's Target Capital Structure

Debt 35%
Preferred 5%
Equity 60%

Additional Financial Information

Marginal Tax Rate 35%
Floatation coasts average 11% for both common and preferred stock
Short Term Treasury yields 2.5%
Market return is 8.5%
Gustafson beta is 0.9
Indefinite expected growth: 3%
Last annual dividend $ 0.50 per share
Expected next years' earnings $ 5,000,000.00
Firm can borrow up to $ 3,500,000.00 at market return of old debt
lenders will demand 7% for borrowing beyond

Investment Opportunity Schedule

Project IRR Capital Requirement

A 14% $ 3,000,000.00
B 8% $ 2,500,000.00
C 6% $ 2,000,000.00
D 5% $ 1,000,000.00
Cost of Capital: Capital Structure TAB

score
A 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 Bonds Issued Bond Face Value
2 $ 18,000,000.00 = 18,000 X $ 1,000.00

Market Value
of Debt = ( PMT X PVFA(k,n) + FV x PVF(k,n) ) X Number of Bonds Issued
2 $ 20,461,993.13 = ( X + x ) X 18,000

k= 0.02 Alternative Method: Bond Price using Excel PV formula X Number of Bonds Issued
n= 40 $1,136.78 X 18,000

Preferred:

Book Value of Preferred Stock

Preferred Stock = Face Value X Preferred Stock Issued
2 $ 2,000,000.00 = $ 100.00 X 20,000

PV of a Perpetuity (Dp/k)
Market Value of Preferred
Preferred Stock = ( Dividend (Dp) / Market Rate (k) ) X Stock Issued
2 $ 2,400,000.00 = ( $ 6.00 / 0.05 ) X 20,000

Equity:

Book Value of Common Issue Retained

Equity = ( Stock issued X Price ) + Earnings
2 $ 26,850,000.00 = ( 2,300,000.00 X $ 9.50 ) + $ 5,000,000.00

Market Value of Common Market

Equity = ( Stock issued X Price )
2 $ 25,875,000.00 = ( 2,300,000.00 X $ 11.25 )

Part 1
page 2 Cost of Capital

Capital Structure Comparison:

Book Market Target

 Value Weight Value Weight Weights
Debt $ 18,000,000.00 38% $ 20,461,993.13 43% 35%
Preferred $ 2,000,000.00 4% $ 2,400,000.00 5% 5%
Equity $ 26,850,000.00 57% $ 25,875,000.00 52% 60%
6 total $ 46,850,000.00 100% $ 48,736,993.13 100% 100%

Comments:
3
I have noticed that debt to equity is close to each other, meaning the company is utilizing their equity well in growing the business. Debt is higher than their target weight.

Total
21
Cost of Capital: Weighted Average Cost of Capital TAB

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

Cost Market Tax

of = yield X ( 1 - Rate )
Debt (kd) (T)
2 2.600% = $ 0.04 X ( 1 - 0.35 )

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 (Kp) (f)
2 5.618% = 0.05 / ( 1 - 0.11 )

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

CAPM:

Cost of Risk Free Market Risk Free

Retained = Rate + ( Return - Rate ) X beta
Earnings (krf) (km) (krf) (bx)
2 7.900% = 0.025 + ( 0.085 0.025 ) X 0.9

Dividend Growth:

Cost of Latest Growth Stock Growth

Retained = ( Dividend X ( 1 + Rate ) / Price )+ Rate
Earnings (D0) g P0 g
2 8.420% = ( 0.5 X ( 1 + 0.03 ) / 9.5 )+ 0.03

Risk Premium:

Cost of Bond 4% Risk

Retained = Yield + Premium
Earnings kd rpe
2 6.500% = 0.025 + 0.04

Reconciliation
2 22.820%

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

Cost of New Latest Growth Floatation Stock Growth

Common = ( Dividend X ( 1+ Rate )) / ( (1- Rate )X Price )+ Rate
Stock (D0) g (f) P0 g
2 9.091% = ( $ 0.50 X ( 1+ 0.03 ) ) / ( (1- 0.11 )X $ 9.50 )+ 0.03
Used stock price from Equity

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

Target Cost Factors

Weights
Debt 35% 2.600% 0.910%
Preferred 5% 5.618% 0.281%
6 Common Equity 60% 9.091% 5.454%

3 WACC 6.6%

Total
23
Capital Rationing: Calculating Breakpoints TAB

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

Dividends:
Next year's
Common Dividend Common
Dividends = per share X Stock issued
2 34,500.00 = (0.50x.03) X 2,300,000.00

Preferred Dividend Preferred

Dividends = per share X Stock issued
2 $ 10,000.00 = $ 0.50 X 20,000

Retained Total
Earnings = Earnings - Dividends
2 $ 4,955,500.00 = $ 5,000,000.00 - $ 44,500.00

Retained Target
Breakpoint = Earnings / Weight
2 $ 8,259,166.67 = $ 4,955,500.00 / 60.000%

h Calculate the WACC after the first breakpoint.

Target Cost Factors

Weights
Debt 35%
Preferred 5%
Equity 60%

i Where is the second breakpoint in the MCC (the point at which the cost of debt increases.)

Additional Target
Breakpoint = Lending Available / Weight
2 = /

j Calculate the WACC after the second break. Calculate to the nearest 0.1%.

Target Cost Factors

Weights
Debt 35%
Preferred 5%
6 Equity 60%

Total
21
MCC - IOS Plot TAB

points
10 k Plot Gustafson's MCC.
10 l Plot Gustafson's IOS on the same axes as the MCC.

16% Gustafson Marginal Cost of Capital and Investment Opportunity Schedule

14%

12%

10%

8%

Cost of
Capital
6%

4%

2%

$2M $4M $6M $8M $10M $12M

Total Capital Raised

Total
20
Capital Planning TAB

points

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

Looking at the graph looks like project a,b should be rejected and C D
should be accepted because the WACC is 6.6%.

n Do any of those rejected have IRRs above the initial WACC? Which ones?

C and D have a higher WACC which is at 6.6%

5

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

Any project that has higher return than its capital can be accepted but in
order to finance projects if capital was increated then they can be
regected. In order to finance projects the capital was increased, since it
was increasted Older projects would need to be rejected.
5

Total
15