207 Risk and Retuen Chapter 6 The Meaning and Measurement of COST OF CAPITAL CASE The balance sheet that follows indicates the optimum capital structure for Nealon Inc. Flotation costs are (a) 3% ofmarket value for a new bond issue, and (b) $1,00 per share for preferred stock The dividends for common stock were $2.51 last year ten years ago the dividends were 1.40 per share. The firm is in a % tax bracket, what is the weighted average cost of capital ifthe finn's finances are in the following proportions? S Amount of Type of Financing Bonds (8%, $1,000 par, 20-year maturity) Preferred stock (5,000 shares outstanding, $50 par, $1.50 dividend) Common equity ($1 par) market value $35 Total $3,000,000 $1,000,000 $6,000,000 . Market prices are $1,135 for bonds, $21 for preferred stock, and $35 for common stock 2. Flotation cost of bonds up to $2,000,000 of bonds is 3%. 3. More than $2M, the flotation cost increase to 10%. 4. The company would obtain the first $3,000,000 of equity from retained earnings. 5. Equity above 3M would be obtained from the sale of new common stock (10% flotation cost) a. b. Calculate the component cost of each type of capital. Calculate the S levels at which the cost of capital would change. And calculate the WACC at each level. c. Assume the following investment opportunities (Investments Available) 1. 2. 3. 4. 5. 6. 7. 8. $600,000 cost return $160,000 per year for 6 years. $800,000 cost returm $300,000 year 1, $400,000 year 2, $400,000 year 3. $1,000,000 cost return $151,426 per year 16 years. $1,500,000 cost return $250,000 years 1-4; $300,000 years 5-10. $850,000 cost, returns $10,000,000 at the end of 25 years. $2,500,000 cost, returns $500,000 per year for seven years. Cost is $1,000,000, returns $2,200,000 at the end of 7 years. Cost $1,750,000 Returns $150,000 for thirty years. Graph the WACC schedule and the IOS schedule, and show the capital expenditure budget for the company. Give the dollar amount of investment spending that maximizes the share price Explain your answer in terms of maximizing shareholder wealth