CHAPTER 11 CASE

Making Star Products Financing/Investment DecisionStar Products Company is a growing manufactures of automobile accessorieswhose stock is actively traded on the over-the-counter market. During 2009, the Dallas-based company experienced sharp increases in both sales and earnings. Because ofthis recent growth, Melissa Jen, the companys treasurer, wants to make sure thatavailable funds are being used to their fullest. Management policy is to maintain thecurrent capital structure proportions of 30% long-term debt, 10% preferred stock, and60% common stock equity for at least the next 3 years. The firm is in the 40% taxbracket.Stars division and product managers have presented several competinginvestment opportunities to Jen. However, because funds are limited, choices of whichprojects to accept must be made. The investment opportunities schedule (IOS) is shownin the below table.Investment Opportunities Schedule (IOS)For Star Products CompanyInvestment OpportunityInternal rate of return (IRR) InitialInvestmentA. 15% $400,000B. 22% $200,000C. 25% $700,000D. 23% $400,000E. 17% $500,000F. 19% $600,000G. 14% $500,000To estimate the firms weighted average cost of capital (WACC), Jen contacted aleadinginvestment bankingfirm, which provided thefinancing costdata shown in thefollowing table.

FinancingCost DataStar Products CompanyLong-term debt: The firm can raise $450,000 of additional debt by selling 15year, $1,000 par value, 9% coupon interest rate bonds that pay annual interest. Itexpects to net $960 per bond after flotation cost. Any debt in excess of $450,000 willhave a before-tax cost, r-d of 13%Preferred stock: Preferred stock, regardless of the amount sold, can be issuedwith a $70 par value and a 14% annual dividend rate and will net $65 per share afterflotation costs.Common stock equity: The firm expects dividends and earnings per share to be$0.96 and $3.20, respectively, in 2010 and to continue to grow at a constant rate of 11%per year. The firms stock currently sells for $12 per share. Star expects to have$1,500,000 of retained earnings available in the coming year. Once the retainedearnings have been exhausted, the firm can raise additional funds by selling newcommon stock, netting $9 per share after underpricing the flotation costs.

A.)

a. Calculate the cost of each source of financing, as specified:

a. Long-term debt, first $450,000

b. Long-term debt, greater than $450,000

c. Preferred stock, all amounts

d. Common stock equity, first $1,500,000

e. Common stock equity, greater than $1,500,000

B.)

Find the break points associated with each source of capital, and use them to specifyeach of the ranges of total new financing over which the firms weighted averagecost of capital (WACC) remains constant.

C.)

Calculate the weighted average cost of capital (WACC) over each of theranges of total next financing specified in part b.

D.)

Using the findings in part c along with the investment opportunities schedule(IOS), draw the firms weighted marginal cost of capital (WMCC) and IOS on thesame set of axes (total new financing or investment on the x axis on weightedaverage cost and IRR on the y axis)

E.)

Which, if any, of the available investments would you recommend that the firmaccept? Explain