Reference no: EM131326889

Art’s Artichokes, Inc. is planning its yearly budget and has the following potential independent proposals:

                                    PROJECT                   OUTLAY                   IRR

                                    A                                 $5,000,000                  10.5%

                                    B                                 $5,000,000                  16.0%

                                    C                                 $8,000,000                  14.0%

                                    D                                 $12,000,000                10.0%

                                    E                                  $12,000,000                12.0%

The firm’s capital structure shown below is considered optimal and will be maintained:

                                    Debt                            $80,000,000

                                    Preferred Stock           $20,000,000

                                    Common Equity          $100,000,000

The firm has a marginal tax rate of 35% and has $5,000,000 of retained earnings available for investment. Four years ago, Art’s paid a common stock dividend of $2.25 a share. Yesterday, they paid a dividend of $3.00. Assume that this dividend growth rate continues for the indefinite future. The market price for its common stock is $49 with a beta of 1.25. Currently, the YTM on T-Bonds is 2.5% and the expected market return is 8.5%.

Art’s can raise funds under the following limitations:

BONDS: New 20-year $1000 par value bonds carrying a coupon of 12% (annual) are priced to yield the investor 10% a year. Flotation costs total $70.27 per bond.

PREFERRED STOCK: Current shares of preferred stock have a dividend of $3.40 and are selling for $40 per share. Underwriters charge a flotation fee of 6% of the selling price.

COMMON STOCK: New common stock requires flotation costs equal to 13% of the stock’s price.

PROBLEM 2:

Calculate each of the following component costs of capital. Be sure to include any changes in component costs as the level of new capital increases.

A. Cost of Debt and After-Tax Cost of Debt

Cost of Preferred Stock

Cost of Equity - Retained Earnings (average of DCF and CAPM methods)

D. Cost of Equity - New Common Stock

PROBLEM 3:

Calculate the Weighted Average Cost of Capital (WACC) for Art’s Artichokes assuming that they will be utilizing retained earnings rather than any new common stock.

Calculate the Weighted Average Cost of Capital (WACC) for Art’s Artichokes if they have to issue new common stock. At what total capital expenditure will this WACC change occur?