Reference no: EM138237

The following capital structure is taken from Bata Boots Co. balance sheet for the fiscal year ended April 30, 2005.  This is considered the firm's optimal capital structure. 

Mortgage Bonds (due 2020)                                      $16,000,000
Debentures (due 2006)                                                 12,000,000
Preferred Share "A" (dividend 12%)                           12,000,000
Preferred Share "B" (dividend $1.80)                            4,000,000
 Common Shares (3,600,000 outstanding)                     8,000,000
Retained Earnings                                                        28,000,000
Total Capital                                                               $80,000,000

For the 2006 fiscal year, Bata Boots is evaluating three independent investment opportunities.  The first (Asset A) costs $9 million and is expected to provide a 14% rate of return.  The second (Asset B) costs $11.5 million and is expected to provide a 16.8% rate of return.  The third (Asset C) costs $17 million and is expected to provide a 13.4% rate of return.

The firm's president, Boots Bailey, wonders which of the three investment opportunities the firm should proceed with.  He has been informed that determining the firm's after-tax cost of capital is the first step in making this decision. Boots has approached you with the following information to see if you can help him with his problem.

The company's common shares have been trading on the Toronto Stock Exchange for the past 28 years; the current price is $17.50 per share. EPS for the previous 10 years is provided below.  Boots has suggested that the past ten years is not a representative time period to estimate future growth. Boots expects future growth will be only 75% of that experienced over the past 10 years.

Bata attempts to maintain a common share dividend pay-out ratio of 40%.  A recent discussion with their underwriters, Revell& Co., indicates that if Boots issued additional common shares, the discount to the current price would be 8%.  In addition, underwriting fees would be $2.10 per share.

The company sold the "A" preferred share issue in 1981 and they currently trade for $31.58. The "B" issue of preferreds were sold in 1985 and they currently trade for $18.95. Both preferreds have $25 stated values.  Revell& Co. has informed Boots that a new issue of preferred shares would require underwriting fees of 5% of the stated value.

The debentures were issued in March 1986, for par, with a coupon rate of 5.5% paid semi-annually. They are rated BB and are quoted at 75.07.  Revell& Co. has informed Boots that the market will only purchase a five-year debenture from Bata Boots. Debentures rated BB with 5 years to maturity are currently trading to yield 11.79%.  The underwriting fees associated with a issue of five-year debentures for Bata would be 2.1% of par and the debentures would sell at a discount of 1.2% of par.

The 20 year mortgage bonds were issued five years ago with a coupon rate of 14%, paid semi­annually. They are now quoted at 118.8.  If Bata issued new 20-year mortgage bonds, the company would have to pay a premium of 29 basis points above the yield on the mortgage bonds currently outstanding.  When sold, the underwriting fees on the new bonds would be 1.8% of par.

Considering the choice of projects given at the beginning of this problem, which project(s) would you recommend Bata Boots Co. accept?  Fully explain.  Bata's tax rate is 40%.