Ezzell Enterprises has the following capital structure, which it considers to be optimal under present and forecasted conditions:

Debt (long-term only) ........ 45%

Common equity .......... 55

Total liabilities and equity ...... 100%

For the coming year, management expects after-tax earnings of $2.5 million. Ezzell’s past dividend policy of paying out 60 percent of earnings will continue. Present commitments from its investment banker will allow Ezzell to borrow according to the following schedule:

Loan Amount Interest Rate_______

$ 1 to $500,000........ 9% on this increment of debt

$500,001 to $900,000........11% on this increment of debt

$900,001 and above ........ 13% on this increment of debt

The company’s marginal tax rate is 40 percent, the current market price of its stock is $22 per share, its last dividend was $2.20 per share, and the expected growth rate is 5 percent. External equity (new common stock) can be sold at a flotation cost of 10 percent.

Ezzell has the following investment opportunities for the next year:

Management asks you to help determine which projects (if any) should be undertaken. You proceed with this analysis by answering the following questions (or performing the tasks) as posed in a logical sequence:
a. How many breaks are there in the MCC schedule? At what dollar amounts do the breaks occur, and what causes them?
b. What is the weighted average cost of capital in each of the intervals between the breaks?
c. What are the expected returns for Projects 1 and 3?
d. Graph the IOS and MCC schedules.
e. Which projects should Ezzell’s management accept?
f. What assumptions about project risk are implicit in this problem? If you learned that Projects 1, 2, and 3 were of above-average risk, yet Ezzell chose the projects that you indicated in part (e), how would this affect the situation?
g. The problem stated that Ezzell pays out 60 percent of its earnings as dividends. How would the analysis change if the payout ratio were changed to zero, to 100 percent, or somewhere in between? (No calculations arenecessary.)

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Annual Cash Flows Expected Return Project Cost Project Life R $675,000 $155,401 268,484 375,000 161,524 562,500 185,194 750,000 127,351 8 years 900,000 15.0% 3 4 10 4 12.0 11.0