AIR CORPORATION

Introduction

Siobhan McGurkin, chief operating officer for the Aviator Corporation, wished she could remember more of her training in financial theory that she had been exposed to in college. Aviator Corporation was a computer services firm that specialized in airborne support.Siobhan had just completed summarizing the financial aspects of four capital investment projects that were open to Aviator during the coming year, and she was faced with the task of recommending which should be selected. Her boss, Mary Marshall, was a "street-smart" chief executive, with no background in financial theory, and CEO of Aviator.

As she headed toward her boss's office, she was most concerned with the knowledge that her boss would immediately favour the project that promised the highest gain in reported net income. Siobhan knew that selecting projects purely on that basis would be incorrect; but she wasn't sure of her ability to convince Mary, who tended to assume financiers thought up fancy methods just to show how smart they were.

Part A

Aviator Corporation is trying to calculate its cost of capital for use in the above capital budgeting decision. Ms. McGurkin, has given you the following information and has asked you to compute the weighted average cost of capital.

The company currently has an outstanding bond with a 9.5 percent coupon rate and another bond with a 7.8 percent rate. The firm has been informed by its investment dealer that bonds of equal risk and credit ratings are now selling to yield 8.0 percent with a flotation cost of 3%. The common stock has a price of $108.44 and an expected dividend (D1) of $3.15 per share. The historical growth pattern (g) for dividends is as follows:

The preferred stock is selling at $90 per share and pays a dividend of $8.50 per share. The corporate tax rate is 20 percent. The flotation cost is 2 percent of the selling price for preferred stock. The optimum capital structure for the firm is 40 percent debt, 30 percent preferred stock, and 30 percent common equity in the form of retained earnings.

Required:

1. the cost of capital for the individual components in the capital structure, and then calculate the weighted average cost of capital.

2. a brief summary to Ms. McGurkin explaining the limitations of using a weighted average cost of capital calculated in this manner.

Part B

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