Murchie's is considering diversification by way of acquisition to reduce its reliance on its volatile core business.

Question:

Murchie's is considering diversification by way of acquisition to reduce its reliance on its volatile core business. Mad Max, the CEO, has asked for your calculation of a discount rate to be used to analyze the potential acquisition targets. The following information has been assembled.

Long-term bonds ................ . ......................$10,000,000
Subordinated perpetual bonds ......... . . . .. . .2,000,000
Common shares ...................... . .. .. . .............2,062,500
Retained earnings .... .. . .. .. .. . ....... . . . .. .......937,500

......................................................................$15,000,000

The yield on 98-day Treasury bills is 7.38 percent. Long-term debt has 15 years to maturity and has a coupon rate of 12 percent paid semiannually. Currently the bonds are trading at a premium of 15 percent to face value. A new debt issue would incur flotation costs of 3 percent of the issue price.
The perpetual bonds were issued at a yield of 9 percent but currently are trading to yield 12 percent. The flotation costs of a new issue would be 4 percent. There are 750,000 common shares outstanding, presently priced at $4.50. Murchie's, with a beta of 1.7, is planning a dividend of $0.10. Future growth is suggested at a compound annualized rate of 15 percent. A new issue of common shares would net the firm $4.10 per share. Murchie's tax rate is 43 percent. Internally generated funds will not be sufficient to fund future expansion plans.
a. Calculate Murchie's weighted average cost of capital.
b. Calculate Murchie's weighted average cost of capital if it has negative income for tax purposes.
c. Comment on the appropriateness of Murchie's present capital structure.
d. Comment on the use of the weighted average cost of capital as calculated to analyze the suggested acquisitions.

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... Discount Rate
Depending upon the context, the discount rate has two different definitions and usages. First, the discount rate refers to the interest rate charged to the commercial banks and other financial institutions for the loans they take from the Federal... 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... Maturity
Maturity is the date on which the life of a transaction or financial instrument ends, after which it must either be renewed, or it will cease to exist. The term is commonly used for deposits, foreign exchange spot, and forward transactions, interest...

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