Making Star Products' Financing/Investment DecisionStar Products Company is a growing manufacturer of automobile accessories whose stock is actively traded on the over-the-counter (OTC) market. During 2012, the Dallas-based company experienced sharp increases in both sales and earnings. Because of this recent growth, Melissa Jen, the company's treasurer, wants to make sure that available funds are being used to their fullest. Management policy is to maintain the current capital structure proportions of

30%

long-term debt,

10%

preferred stock, and

60%

common stock equity for at least the next

3

years. The firm is in the

40%

tax bracket.

Star's division and product managers have presented several competing investment opportunities to Jen. However, because funds are limited, choices of which projects to accept must be made. Star's current investment opportunities are shown in the table below.

nvestment Opportunities
for Star Products Company
Investment opportunity	Internal rate of return (IRR)	Initial investment
A	15%	$400,000
B	22	200,000
C	25	700,000
D	23	400,000
E	17	500,000
F	19	600,000
G	14	500,000

To estimate the firm's weighted average cost of capital (WACC), Jen contacted a leading investment banking firm, which provided the financing cost data shown in the following table.

Financing Cost Data

Star Products Company

Long-term debt: The firm can raise

$450,000

of additional debt by selling

15-year,

$1,000-par-value,

9.0%

coupon interest rate bonds that pay annual interest. It expects to net

$960

per bond after flotation costs. Any debt in excess of

$450,000

will have a before-tax cost,

rd,

of

13.0%.

Preferred stock: Preferred stock, regardless of the amount sold, can be issued with a

$70

par value and a

14.0%

annual dividend rate and will net

$65

per share after flotation costs.

Common stock equity: The firm expects dividends and earnings per share to be

$0.96

and

$3.20,

respectively, in 2013 and to continue to grow at a constant rate of

11.0%

per year. The firm's stock currently sells for

$12.00

per share. Star expects to have

$1,500,000

of retained earnings available in the coming year. Once the retained earnings have been exhausted, the firm can raise additional funds by selling new common stock, netting

$9.00

per share after underpricing and flotation costs.

To Do

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

(1) Long-term debt, first

$450,000.

(2) Long-term debt, greater than

$450,000.

(3) Preferred stock, all amounts.

(4) Common stock equity, first

$1,500,000.

(5) Common stock equity, greater than

$1,500,000.

b. Calculate Star's weighted average cost of capital (WACC) for each of the following situations:

(1) Long-term debt less than

$450,001

and common stock equity less than

$1,500,001.

(2) Long-term debt greater than

$450,000

and common stock equity less than

$1,500,001.

(3) Long-term debt greater than

$450,000

and common stock equity greater than

$1,500,000.

c. Answer the following questions while considering Star's current capital structure and your answers to part

(b).

Be sure to explain your answers.

(1) How much long-term debt can Star use before affecting its cost of common stock?

(2) What is the maximum amount of financing that Star can raise without using the more expensive new common stock?

(3) In part

(b),

why were you not asked to calculate Star's WACC when long-term debt is less than

$450,001

and common stock equity is greater than

$1,500,000?

d. Regardless of Star's WACC, rank the projects according to most attractive to least attractive and explain your ranking procedure.

e. Based on the current capital structure and each of the financing scenarios below, determine which investment opportunities Star should undertake. Explain your answers.

(1) Long-term debt of

$450,000.

(2) Common stock equity of

$750,000.

(3) Common stock equity of

$1,500,000.

(4) Long-term debt of

$1,000,000.