The Marietta Corporation, a large manufacturer of mufflers

The Marietta Corporation, a large manufacturer of mufflers, tailpipes, and shock absorbers, is currently carrying out its financial planning for next year. In about two weeks, at the next meeting of the firms board of directors, Frank Bosworth, vice president of finance, is scheduled to present his recommendations for next years overall financial plan. He has asked Donna Botello, manager of financial planning, to gather the necessary information and perform the calculations for the financial plan. The companys divisional staff s, together with corporate finance department personnel, have analyzed several proposed capital expenditure projects. The following is a summary schedule of acceptable projects (defined by the company as projects having internal rates of return greater than 8 percent):

Project Investment Amount (in Millions of Dollars) Internal Rate of Return

A $10.0 25%

B 20.0 21

C 30.0 18

D 35.0 15

E 40.0 12.4

F 40.0 11.3

G 40.0 10

H 20.0 9

All projects are expected to have one year of negative cash fl ow followed by positive cash flows over the remaining years. In addition, next years projects involve modifications and expansion of the companys existing facilities and products. As a result, these projects are considered to have approximately the same degree of risk as the companys existing assets. Botello feels that this summary schedule and detailed supporting documents provide her with the necessary information concerning the possible capital expenditure projects for next year. She can now direct her attention to obtaining the data necessary to determine the cost of the capital required to finance next years proposed projects.

The companys investment bankers indicated to Bosworth in a recent meeting that they feel the company could issue up to $50 million of 9 percent first-mortgage bonds at par next year. The investment bankers also feel that any additional debt would have to be subordinated debentures with a coupon of 10 percent, also to be sold at par. The investment bankers rendered this opinion after Bosworth gave an approximate estimate of the size of next years capital budget, and after he estimated that approximately $100 million of retained earnings would be available next year. Both the companys financial managers and its investment bankers consider the present capital structure of the company, shown in the following table, to be optimal (assume that book and market values are equal):

Debt $ 400,000,000

Stockholders equity:

Common stock 150,000,000

Retained earnings 450,000,000

$1,000,000,000

Botello has assembled additional information, as follows:

Marietta common stock is currently selling at $21 per share.

The investment bankers have also indicated that an additional $75 million in new common stock could be issued to net the company $19 per share.

The companys present annual dividend is $1.32 per share. However, Bosworth feels fairly certain that the board will increase it to $1.415 per share next year.

The companys earnings and dividends have doubled over the past 10 years. Growth has been fairly steady, and this rate is expected to continue for the foreseeable future. The companys marginal tax rate is 40 percent.

Using the information provided, answer the following questions.

1. Calculate the after-tax cost of each component source of capital.

2. Calculate the marginal cost of capital for the various intervals, or packages, of capital the company can raise next year. Plot the marginal cost of capital curve.

3. Using the marginal cost of capital curve from question 2, and plotting the investment opportunity curve, determine the companys optimal capital budget for next year.

4. Should Project G be accepted or rejected? Why?

5. What factors do you feel might cause Bosworth to recommend a different capital budget than the one obtained in question 3?

6. Assume that a sudden rise in interest rates has caused the cost of various capital components to increase. The pretax cost of first-mortgage bonds has increased to 11 percent; the pretax cost of subordinated debentures has increased to 12.5 percent; the companys common stock price has declined to $18; and new stock could be sold to net Marietta $16 per share.

a. Recompute the after-tax cost of the individual component sources of capital.

b. Recompute the marginal cost of capital for the various intervals of capital Marietta can raise next year.

c. Determine the optimal capital budget for next year at the higher cost of capital.

d. How does the interest rate surge affect Mariettas optimal capital budget?

Debentures
Debenture DefinitionDebentures are corporate loan instruments secured against the promise by the issuer to pay interest and principal. The holder of the debenture is promised to be paid a periodic interest and principal at the term. Companies who...
Common Stock
Common stock is an equity component that represents the worth of stock owned by the shareholders of the company. The common stock represents the par value of the shares outstanding at a balance sheet date. Public companies can trade their stocks on...
Capital Structure
Capital structure refers to a company’s outstanding debt and equity. The capital structure is the particular combination of debt and equity used by a finance its overall operations and growth. Capital structure maximizes the market value of a...
Cost Of Capital
Cost of capital refers to the opportunity cost of making a specific investment . Cost of capital (COC) is the rate of return that a firm must earn on its project investments to maintain its market value and attract funds. COC is the required rate of...
Coupon
A coupon or coupon payment is the annual interest rate paid on a bond, expressed as a percentage of the face value and paid from issue date until maturity. Coupons are usually referred to in terms of the coupon rate (the sum of coupons paid in a...
Dividend
A dividend is a distribution of a portion of company’s earnings, decided and managed by the company’s board of directors, and paid to the shareholders. Dividends are given on the shares. It is a token reward paid to the shareholders for their...