COURSE : CORPORATE FINANCIAL MANAGEMENT II CORPORATE FINANCE PRINCIPLES. COURSE CODE : FIN402

QUESTION 4

Chedarwood Limited has the following capital structure that represents the companys optimal capital structure:

RM

Preferred stocks 18,000,000

Common stocks 37,000,000

Retained earnings 12,000,000

Bonds 43,000,000

Chedarwood Limited is planning to undertake a capital expenditure programme in January 2020 that will require an initial outlay of RM8,500,000. To finance the planned capital expenditure, Chedarwood Limited will raise the new funds as follows:

i. Issue 10% irredeemable bonds at RM875 with a flotation cost of 10% from the issue price. The par value of the bond is RM1,000.

ii. Issue 11% preferred stocks with a nominal value of RM100 at a discount of 4%. The cost associated with the issue is 2% of the par value.

iii. The common stocks are selling at RM15.00 per share. If new stocks are to be issued, the flotation cost is 10% of the market value. Dividends are expected to grow at a constant rate of 7% per annum for the foreseeable future.

Last years dividends for both the common stocks and the preferred stocks have recently been paid. The common stock dividends paid out were RM1.50 per share. 50% of the retained earnings are available to finance capital expenditure next year. The corporate tax rate is 27%.

Required:

a. Explain what is meant by optimal capital structure.