Aespa Company is in the process of determining its capital budget for the coming fiscal year. Aespa
Question:
Aespa Company is in the process of determining its capital budget for the coming fiscal year. Aespa Company s balance sheet reflects five sources of long-term funds. The current outstanding amounts from these five sources are shown below and represent the company s historical sources of funds fairly accurately.
Source of Funds
P Amount (in millions)
%
Mortgage bonds (P1,000 par, 7-1/2%)
135
15.0
Debentures (P1,000 par, 8%, due 20x5)
225
25.0
Preference share (100 par, 7-1/2%)
90
10.0
Ordinary share (P10 par)
150
16.7
Retained earnings
300
33.3
900
100.0
Aespa will raise the funds necessary to support the selected capital investment projects so as to maintain its historical distribution among the various sources of long-term funds. Thus, 15 percent will be obtained from additional mortgage bonds on new plant, 25 percent from debentures, 10 percent from preferred stock, and 50 percent from some ordinary equity source. Aespa s policy is to reinvest the funds derived from each year s earnings in new projects. Aespa issues new ordinary shares only after all funds provided from retained earnings have been exhausted.
Management estimates that its net income after taxes for the coming year will be P4.50 per ordinary share. The dividend payout ratio will be 40 percent of earnings to ordinary shareholders (P1.80 per share), the same ratio as the prior 4 years. The preference shareholders will receive P6.75 million. The retained earnings will be used as needed to support the capital investment program.
The capital budgeting staff, in conjunction with Aespa s investment broker, has developed the following data regarding Aespa s sources of funds if it were to raise funds in the current market.
Source of funds
Par Value (P)
Dividend Rate (%)
Issue Price (P)
Mortgage bonds
1,000
14
1,000
Debentures
1,000
14-1/2
1,000
Preference share
100
13-1/2
99.25
Ordinary share
10
13-1/2
67.50
The estimated interest rates on the debt instruments and the dividend rate on the preference share are based upon the rate being experienced in the market by firms which are of the same size and quality of Aespa. The investment banker believes that the price of P67.50 for the ordinary share is justified, since Aespa s price/earnings ratio of 15 is consistent with the 10 percent earnings growth rate that the market is capitalizing. Aespa is subject to 40 percent income tax rate.
Required:
1. Calculate Aespa s after-tax marginal cost of capital for each of the five sources of capital. (10 pts)
2. Calculate Aespa s after-tax weighted average cost of capital. (3 pts)
3. Aespa follows the practice that 50 percent of any funds raised will be derived from ordinary equity sources. Determine the point of expansion at which Aespa s source of ordinary equity funds would switch from retained earnings to new ordinary stock in the coming year. (5 pts)
Intermediate Accounting
ISBN: 978-0324300987
10th Edition
Authors: Loren A Nikolai, D. Bazley and Jefferson P. Jones