Gustafson Financial Information TAB You will find all the given data here

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Mark Webster
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1 ACCT 2040 / FN 2040 Financial Management SLOA Problem Introduction Tab This financial planning project is split into several parts Each section has its own tab. Section Problem Introduction TAB This tab Gustafson Financial Information TAB You will find all the given data here 1 Cost of Capital : Capital Structure TAB This section is split into two tabs: Cost of Capital A and Cost of Capital B Cost of Capital A concentrates on the developing Gustafson Capital Structure Problem: a) Calculate the firm's capital structure based on book and market values and compare with the target capital structure. 2 Cost of Capital: WACC TAB Cost of Capital B concentrates on calculating Gustafson's WACC b) Calculate the cost of debt based on the market return on the company's existing bonds. c) Calculate the cost of preferred stock based on the market return on the company's existing preferred stock d) Calculate the cost of retained earnings using three approaches, CAPM, dividend growth, and risk premium. Reconcile the results into a single estimate e) Estimate the cost of equity raised through the sale of new stock using the dividend growth approach f) Calculate the WACC using equity from retained earnings based on your component cost estimates and the target capital structure 3 Capital Rationing: Finding the Break TAB This section calculate the break g) Where is the first breakpoint in the MCC (the point where retained earnings runs out)? Calculate to the nearest $.1M. h) Calculate the WACC after the first breakpoint. i) Where is the second breakpoint in the MCC (the point at which the cost of debt increases.) j) Calculate the WACC after the second break. Calculate to the nearest $0.1M. 4 MCC - IOS Plot TAB In this section we plot the Marginal Cost of Capital and the Investment Opportunity Schedule This tab MCC-IOS is to be used as a template for your graphs Use the Commands Insert>line and Insert>rectangle to create your plot k) Plot Gustafson's Marginal Cost of Capital. l) Plot Gustafson's IOS on the same axes as the MCC. 5 Capital Planning TAB In this section, we analyze our data and make our conclusions m) Which projects should be accepted and which should be rejected? n) Do any of those rejected have IRRs above the initial WACC? Which ones? o) If so, explain in words why they're being rejected. p) What is the WACC for the planning period? Answers are to be entered in the black outlined, yellow boxes Supporting data is to be entered in the underlined yellow boxes. Enter all percentages as decimals

2 Gustafson Gutters Financial Data Debt issued 18, year bonds 10 years ago at $ 1, par value with 5% coupon rate similar bonds now selling at 4% Preferred Stock issued 20,000 shares 6 years ago at $ par value with dividend of $6 similar preferred issues are now selling at 5% Equity issued 2,300,000 shares at $ 9.50 Accumulated retained earning is now $ 5,000, stock closed at $ Torborg's Target Capital Structure Debt 35% Preferred 5% Equity 60% Additional Financial Information Marginal Tax Rate 35% Floatation coasts average 11% for both common and preferred stock Short Term Treasury yields 2.5% Market return is 8.5% Gustafson beta is 0.9 Indefinite expected growth: 3% Last annual dividend $ 0.50 per share Expected next years' earnings $ 5,000, Firm can borrow up to $ 1,500, at market return of old debt lenders will demand 7% for borrowing beyond Investment Opportunity Schedule Project IRR Capital Requirement A 14% $ 3,000, B 8% $ 2,500, C 6% $ 2,000, D 5% $ 1,000,000.00

3 Cost of Capital: Capital Structure TAB score A Calculate the firm's capital structure based on book and market values and compare with the target capital structure. Debt: Book Value of Debt Number of Bonds Issued Bond Face Value 2 $ 18,000, = 18,000 X $ 1, Market Value of Debt Excel: Bond Price using Excel PV formula X Number of Bonds Issued 2 $ 20,446, ,136 X 18,000 Preferred: Book Value of Preferred Stock Preferred Stock = Face Value X Preferred Stock Issued 2 $ 2,000, = $ X 20,000 PV of a Perpetuity (Dp/k) Market Value of Preferred Preferred Stock = ( Dividend (Dp) / Market Rate (k) ) X Stock Issued 2 $ 2,400, = ( $ 6.00 / 0.05 ) X 20,000 Equity: Book Value of Issue Equity = ( Stock issued X Price ) + 2 $ 26,850, = ( 2,300, X $ 9.50 ) + $ Retained Earnings 5,000, Market Value of Market Equity = ( Stock issued X Price ) 2 $ 25,875, = ( 2,300, X ) Part 1 page 2 Cost of Capital Capital Structure Comparison: Book Market Target Value Weight Value Weight Weights Debt $ 18,000, % $ 20,446, % 35% Preferred $ 2,000, % $ 2,400, % 5% Equity $ 26,850, % $ 25,875, % 60% 6 total $ 46,850, % $ 48,721, % 100% 3 Comments: The company's book value weights are failrly close to their target, but when comparing the market to target weights we see that debt is lower than the target percentage and Equity is higher. 21

4 Cost of Capital: Weighted Average Cost of Capital TAB B Calculate the cost of debt based on the market return on the company's existing bonds. Cost Market Tax of = yield X ( 1 - Rate ) Debt (kd) (T) % = 0.04 X ( ) C Calculate the cost of preferred stock based on the market return on the company's existing preferred stock Cost of Market Floatation Preferred = Rate / ( 1 - Rate ) Stock (Kp) (f) % = 0.05 / ( ) D Calculate the cost of retained earnings using three approaches, CAPM, dividend growth, and risk premium. Reconcile the results into a single estimate CAPM: Cost of Risk Free Market Risk Free Retained = Rate + ( Return - Rate ) X beta Earnings (krf) (km) (krf) (bx) % = ( ) X 0.9 Dividend Growth: Cost of Latest Growth Stock Growth Retained = ( Dividend X ( 1 + Rate ) / Price ) + Rate Earnings (D0) g P0 g % = ( 0.5 X ( ) / ) Risk Premium: Cost of Bond Risk Retained = Yield + Premium Earnings kd rpe % = E Reconciliation 7.826% Estimate the cost of equity raised through the sale of new stock using the dividend growth approach Cost of New Latest Growth Floatation Stock Growth = ( Dividend X ( 1 + Rate ) ) / ( ( 1 - Rate ) X Price ) + Rate Stock (D0) g (f) P0 g % = ( $ 0.50 X ( ) ) / ( ( ) X $ ) F Calculate the WACC using equity from retained earnings based on your component cost estimates and the target capital structure Target Cost Factors Weights Debt 35% 3.860% % Preferred 5% 5.618% % 6 Equity 60% 7.826% % 3 WACC 6.3% 23

5 Capital Rationing: Calculating Break TAB g Where is the first breakpoint in the MCC (the point where retained earnings runs out)? Calculate to the nearest $.1M. Dividends: Dividend Dividends = per share X 2 1,150, = $ 0.50 X Preferred Dividend Dividends = per share X 2 $ 120, = $ 6.00 X Stock issued 2,300, Preferred Stock issued 20,000 Retained Earnings = Earnings - Dividends 2 $ 4,880, = $ 5,000, $ 120, Retained Target Breakpoint = Earnings / Weight 2 $ 8,133, = $ 4,880, / 60% h Calculate the WACC after the first breakpoint. Target Cost Factors Weights Debt 35% 3.86% % Preferred 5% 5.62% % Equity 60% 8.14% % % i Where is the second breakpoint in the MCC (the point at which the cost of debt increases.) Additional Target Breakpoint = Lending Available / Weight 2 $ 2,500, = $1,500,000 / 60% j Calculate the WACC after the second break. Calculate to the nearest 0.1%. Target Cost Factors Weights Debt 35% 7.00% % Preferred 5% 5.618% % 6 Equity 60% 8.14% % % 21

6 MCC - IOS Plot TAB 10 k Plot Gustafson's MCC. 10 l Plot Gustafson's IOS on the same axes as the MCC. 16% Gustafson Marginal Cost of Capital and Investment Opportunity Schedule 14% 12% 10% 8% Cost of Capital 6% 4% 2% $2M $4M $6M $8M $10M $12M Capital Raised 20

7 Capital Planning TAB m Which projects should be accepted and which should be rejected? Accept: A and B Reject: C and D 5 n Do any of those rejected have IRRs above the initial WACC? Which ones? 5 No o If so, explain in words why they're being rejected. N/A 5 15

The Cost of Capital 1

The Cost of Capital 1 Learning Goals Sources of capital Cost of each type of funding Calculation of the weighted average cost of capital (WACC) Construction and use of the marginal cost of capital schedule