04 Jun CALCULATE THE COST OF THE PREFERRED SHARES.
Question
Group Project 2
Question 6
2.
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.
Year EPS Year EPS
1996 $0.34 2001 $0.85
1997 0.41 2002 1.02
1998 0.50 2003 1.22
1999 0.59 2004 1.46
2000 0.71 2005 1.75
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 preferred were sold in 1985 and
they currently trade for $18.95. Both preferred 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%. XXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXIndividual Assignment
9–10 Cost of reinvested profits versus new common shares—DVM
Using the data for each firm shown in the following table, calculate the cost
of reinvested profits and the cost of new common shares using the
constant-growth DVM.
9–4 Cost of debt For each of the following bonds,
calculate the after-tax cost of debt. Assume the coupons are paid
semi-annually, that the tax rate is 40 percent, and that we are dealing with
$1,000 of par value.
9–21 WACC, MCC, and IOS Cartwell Products has
compiled the data shown in the following table for the current costs of its
three sources of capital—long-term debt, preferred equity, and common
equity—for various ranges of new financing.
The company’s
optimal capital structure, which is used to calculate the weighted average cost
of capital, is shown in the following table.
a. Determine
the break points and ranges of new financing associated with each source of
capital. At what financing levels will Cartwell’s weighted average cost of
capital change?
b. Calculate
the weighted average cost of capital for each range of total new financing
found in a. (Hint: There are three ranges.)
c. Using
the results of b along with the following information on the available
investment opportunities, draw the firm’s marginal cost of capital (MCC)
schedule and investment opportunities schedule (IOS).
d. Which,
if any, of the available investments do you recommend that the firm select?
Explain your answer.
e. Now
calculate the overall cost of capital for Cartwell Products. Which projects
should the firm select? Does your answer differ from your answer to part d? If
so, explain why.
9–6 Cost of preferred equity Taylor Systems has
just issued preferred shares. The shares have a 12 percent annual dividend and
a $100 stated value and were sold at $97.50 per share. In addition, flotation costs
of $2.50 per share must be paid.
a. Calculate
the cost of the preferred shares. What is the after-tax cost of the preferred
shares?
b. If
the firm sells the preferred stock with a 10 percent annual dividend and nets
$90 after flotation costs, what is its cost?
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