Homework SourseWith several new investment opportunities it is necessary fo
With several new investment opportunities, it is necessary for you to first know AB Designs’ weighted average cost of capital (WACC). This critical information will inform your analysis on what investments are profitable along with identifying the best financing option.
Business Problem:
AB Designs capital structure is composed of the following sources and target weights that represent the proportion of use for each. AB Designs tax rate is 40%.
Source of Capital
Weight
Long-term loan
10%
Long-term bonds
30%
Preferred Stock
5%
Common Stock Equity
55%
Debt:
AB Designs has a long-term loan with North Shore bank, financed at a 10% interest rate.
AB Designs can sell a 20-year, $1,000 par value, 9 percent bond for $980. A flotation cost of 2 percent of the face value would be required in addition to the discount of $20.
Preferred Stock:
AB Designs has determined it can issue preferred stock at $65 per share par value. The stock will pay an $8.00 annual dividend. The cost of issuing and selling the stock is $3 per share.
Common Stock:
AB Design’s common stock is currently selling for $40 per share. The dividend expected to be paid at the end of the coming year is $5.07. Its dividend payments have been growing at a constant rate for the last five years. Five years ago, the dividend was $3.45. It is expected that to sell, a new common stock issue must be underpriced at $1 per share and the firm must pay $1 per share in flotation costs.
Identify AB Designs’ WACC.
With an understanding of the company’s weighted average cost of capital, you can now analyze the different investment opportunities to determine which projects will most benefit the company.
Business Problem:
AB Designs is considering six growth opportunities that are projected to earn the following rates of return, as provided by the finance department:
Option
Rate of Return
New Clothing Line
20%
New Branding
14%
Store Expansion
18%
Store Modernization
17%
New Ad Campaign
13%
New Property
16%
AB Designs has projected an availability of capital over each of the next three years to be $850,000, $1,000,000, and $1,200,000, respectively. The total projected revenue of three years from each of the six projects and their yearly capital outlays are summarized in the table below in $1,000,000’s.
Capital Outlay
Options
Year 1
Year 2
Year 3
Projected Revenue
New Clothing Line
0.35
0.55
0.75
5.2
New Branding
0.25
0.75
0.25
2.5
Store Expansion
0.50
0.50
0
3.6
Store Modernization
0.35
0.40
0.45
3.2
New Ad Campaign
0.30
0.50
0.20
3.0
New Property
0.50
0
0
2.8
Monies not invested in these projects in a given year will NOT be available for the following year\'s investment in the projects.
Leadership has decided to only undertake two of the projects. If the store expansion project is selected, AB Designs will plan to also modernize the store.
Identify the projects AB Designs should invest in and the goal they will achieve, as a result.
| Source of Capital | Weight |
| Long-term loan | 10% |
| Long-term bonds | 30% |
| Preferred Stock | 5% |
| Common Stock Equity | 55% |
Solution
1st problem,
the wacc would be :
1.weight of long term loan (interest rate of long term loan)(tax rate)0.1*0.1*0.6=0.006
weight of bonds*interest rate of bonds *tax rate
interest rate on bonds calcualtion:
fv=1000
pv=(958) =(980-2-20)
n=20
pmt=90
i/y=9.47
so the long term bonds weight* rate of interest *tax rate
(0.3)(0.0947)(0.6)=0.017
cost of prefered stock : 8/62= 0.129
weight of preffered stock is
0.05*0.129=0.0065
cost of equity Re= d1/po +g
calculate the arte of dividends growth:
3,45(1+g)^4=5.07
g=10%
now putting in the g in the formula we get
5.07/38+0.10=0.2439
weight is 0.55*0.2268=0.1342
so wacc will be 16.37
