Longone Inc.’s management has been asked to consider the acquisition of a competitor. The acquired competitor is expected to generate a 12% return on assets. As CFO you were given the responsibility to prepare a proposal as to how to fund this project as concerns over the current debt as a % of total assets and the preservation of the current dividend yield have been expressed by the Board of Directors.

Total cost of the acquisition is estimated at $60,000,000. The current debt as a percentage of total assets is 59%. The current dividend reflects a pay-out ratio of 30% or $2.50 per share and the Board approved dividend goal is a 2.5% annual growth rate. The current share price is $45.00 and is considered the market price for any new issuances. A recent change in government has resulted in corporate taxes increasing to 29% of taxable income.

You have come up with two strategies and need to develop a recommendation of one or the other. The details of each new issue are provided below:

Option A) - new issues

- Bond issue - 30 years - $27,000,000 - Coupon rate - 8.55% - Flotation costs of 1.0%

- Equity - $23,000,000 - Flotation costs - 1.75%

Option B)

- Mortgage - 25 years - $15,000,000 - Fixed rate – 8.5% (including financing fees)

- Term loan - 10 years - $11,000,000 - Fixed Rate – 7.5% (including financing fees)

- Equity - $34,000,000 - Flotation costs - 1.5%

REQUIRED: (show all calculations)

a) Determine the weighted average cost of capital for each Option. (10 marks)

b) Which Option would you recommend the CFO present to the Board? (3 marks)

c) Would either option meet financing objectives for the business? (2 marks)

Answer rating: 100% (QA)

Answers a The WACCs of both the options are calculated below OPTION A 1 Before tax cost of debt YTM of bonds YTM using a calculator 864 Inputs for YTM ... View the full answer