Solution for d, e, and f ABCDELatimore Constructions Corp has the following capital situation:Debt: The firm issued 10,000 25 year bonds 10 years ago at their par value of $1000. Thebonds carry a coupon rate of 8% and are now selling to yield 10%.Preferred Stock: The company sold 30,000 shares of preferred stock six years ago at a par valueof $50. The shares pay a dividend of 8%. Similar securities are no yielding 9%.Equity: Latimore's initial financing was a sale a 2 million shares of common stock at $12 pershare. Retained Earnings are now $5 million. The current stock price is $13.25.The Target capital structure that Latimore aims to maintain is 30% debt, 5% preferred stock and65% common stock.Other information: Latimore's marginal tax rate (state and federal) is 40%. Flotation costs average 12% for common and preferred stock. Short term Treasury bills currently yield 7.5%.The expected return on stocks is 12.5%.Latimore's beta is 1.20.Latimore expects steady growth at 6% to continue. The last annual dividend was $1.00 per share. Latimore expects to earn $5 million after taxes next year. The firm can borrow an additional $2 million at rates similar to the market rate on itsexisting debt. Beyond that, lenders are expected to demand a higher return in the areaof 14%. The following capital budgeting projects are under consideration:Capital Required$3 million$2 million$2 million$2 million$2 millionCumulative Capital$3 million$5 million$7 million$9 million$11 millionProjectIRR15%14%13%12%11%Complete the following assignment:a. Calculate the firm's existing capital structure based on book value and again based onmarket value. How does it compare to the target capital structure?Book value:Debt = 10,000 x 1,000 = 10,000,000FocusB IU 2 A = = Market Value:Debt = 10,000,000 x 8% / 10 % = 8,000,000%3DThe percentage of debt under the market and book value capital structure is less than 30 %which shows the company is using less than the target debt proportion. Preferred stock hasbeen mentioned at less than 4% of total capital but under the target, it has been around 5%which means the company is using less preferred capital than the target structure. According tothe target capital structure, the equity comprises 65% in the total capital but according to themarket and book value the equity is 755 so it shows that the company has used more equity.b. What is the current cost of debt for the company? 4.8%c. What is the cost of preferred stock ? 8%= 8% x 50/ 50 = 4/50d. Estimate the cost of equity rased by issuing new shares using the dividend growth method.e. Calculate the cost of retained earnings using three approaches; CAPM, dividend growthmethod and risk premium. Reconcile the three approaches into a single estimate for the cost ofretained earnings.f. Using the target capital structure, calculate the WACC, including retained earnings.g. Where is the first breakpoint in the Marginal Cost of Capital (MCC). That is, the point whereretained earnings run out.h. Calculate the WACC after the first breakpoint.i, Calculate the WACC after the second breakpoint.k. Plot the MCC for Latimore.1. Which projects should be accepted and which projects should be rejected, based on thisanalysis only?FocusAE E

Question

Solution for d, e, and f ABCDELatimore Constructions Corp has the following capital situation:Debt: The firm issued 10,000 25 year bonds 10 years ago at their par value of $1000. Thebonds carry a coupon rate of 8% and are now selling to yield 10%.Preferred Stock: The company sold 30,000 shares of preferred stock six years ago at a par valueof $50. The shares pay a dividend of 8%. Similar securities are no yielding 9%.Equity: Latimore's initial financing was a sale a 2 million shares of common stock at $12 pershare. Retained Earnings are now $5 million. The current stock price is $13.25.The Target capital structure that Latimore aims to maintain is 30% debt, 5% preferred stock and65% common stock.Other information:> Latimore's marginal tax rate (state and federal) is 40%.> Flotation costs average 12% for common and preferred stock.> Short term Treasury bills currently yield 7.5%.The expected return on stocks is 12.5%.Latimore's beta is 1.20.Latimore expects steady growth at 6% to continue.> The last annual dividend was $1.00 per share.> Latimore expects to earn $5 million after taxes next year.> The firm can borrow an additional $2 million at rates similar to the market rate on itsexisting debt. Beyond that, lenders are expected to demand a higher return in the areaof 14%.> The following capital budgeting projects are under consideration:Capital Required$3 million$2 million$2 million$2 million$2 millionCumulative Capital$3 million$5 million$7 million$9 million$11 millionProjectIRR15%14%13%12%11%Complete the following assignment:a. Calculate the firm's existing capital structure based on book value and again based onmarket value. How does it compare to the target capital structure?Book value:Debt = 10,000 x 1,000 = 10,000,000FocusB IU 2 A = = Market Value:Debt = 10,000,000 x 8% / 10 % = 8,000,000%3DThe percentage of debt under the market and book value capital structure is less than 30 %which shows the company is using less than the target debt proportion. Preferred stock hasbeen mentioned at less than 4% of total capital but under the target, it has been around 5%which means the company is using less preferred capital than the target structure. According tothe target capital structure, the equity comprises 65% in the total capital but according to themarket and book value the equity is 755 so it shows that the company has used more equity.b. What is the current cost of debt for the company? 4.8%c. What is the cost of preferred stock ? 8%= 8% x 50/ 50 = 4/50d. Estimate the cost of equity rased by issuing new shares using the dividend growth method.e. Calculate the cost of retained earnings using three approaches; CAPM, dividend growthmethod and risk premium. Reconcile the three approaches into a single estimate for the cost ofretained earnings.f. Using the target capital structure, calculate the WACC, including retained earnings.g. Where is the first breakpoint in the Marginal Cost of Capital (MCC). That is, the point whereretained earnings run out.h. Calculate the WACC after the first breakpoint.i, Calculate the WACC after the second breakpoint.k. Plot the MCC for Latimore.1. Which projects should be accepted and which projects should be rejected, based on thisanalysis only?FocusAE E

Accepted Answer

The cost of equity:
The required return on an equity stock by its equity shareholders is the cost of…