2.the mcclain & moss brassiere company has determined that their

2.The McClain & Moss Brassiere Company has determined that their optimal capital structure is

Debt  50%

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Up to $3.0 million of new debt may be raised at a before-tax cost of 6 percent and additional debt (more than $3.0 million) will cost 8 percent for the entire amount of new debt.  The firm will have retained earnings of $3,000,000 available for capital projects next year.  The current price of the stock is $40 per share and the last dividend was (Do = $2.00).  The M&M Company has a tax rate of 40 percent and anticipates a return of (ROE)=13.0 percent on new equity investments. The firms’ earnings per share is $4.00 (E0= $4.00) and the growth implied by the retention ratio and return on new equity invested capital is expected to continue for the future, g=(1-p)*ROE.  You also find that the 10-year US Treasury rate is 4 percent, the stock has a beta (β) of 1.565 and the market risk premium is 5.0%.  New common stock may be issued with a flotation cost of $7 per share.  Please draw the weighted average cost of capital (WACC) marginal cost curve for capital available for M&M Company new capital investment.  (Hint:  Plot the weighted average cost of capital showing break points on the M.C. curve.  Break points on the MC curve are created when the cost of debt or the cost of equity changes.  Changes in the cost of equity occur when the company runs out of retained earnings and must sell new stock and the cost of debt changes when the firm exceeds $3.0 million of new debt and the cost of debt increases. For an example, see the class handout).  To plot the curve, you will need to estimate the cost of new debt and new equity investment levels.

 

a.Estimate the cost of debt for up to $3,000,000 of new debt and for new debt exceeding $3,000,000 of new debt funding.

 

 

b.Using both the CAPM and DCF models, estimate the cost of the $3,000,000 of retained earnings and then using the DCF approach estimate the cost of new issue common stock with a flotation cost of 7%.

 

 

 

15%

 

 

WACC

 

10%

 

 

 

 

 5%

 

 

 

 

 

$ New Capital Raised

 

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