Problem 2. Cost of Capital and Capital Project (8%)

GMA Inc. is contemplating spending $25 million to expand its mining operation,

a project that is considered to have a reasonable amount of risk. Based on some initial

analysis, the project would expand the operations production output by 18% and

provide a 15% return on investment.

Before deciding whether to proceed with the venture, the CEO asked the treasurer

to determine where the financing would come from and how much each source will

cost. The following are the findings of the treasurer:

a) $11 million will be funded from common shares. Each share will be sold

for $50, yielding $4 in dividends. The flotation costs will be 10%.

b) $3 million will be provided from internal sources (retained earnings).

c) $1 million will be generated from preferred shares. The expected selling

price is $100, and the flotation costs will be $5 per share. An amount of

$10 in annual dividends per share will be paid to the preferred

shareholders.

d) $4 million will be funded by the selling of bond A and $6 million by the

selling of Bond B. The cost of Bond A is estimated at 6% and the cost of

Bond B at 8%.

The companys corporate tax rate is 47%. The treasurer expects the common shares

to continue to grow at a rate of 5% per year.

Questions Show your detailed calculations. No grade will be awarded for providing the final number without detailed support to your answer.

1. Calculate the companys cost of capital.

2. Should the CEO approve the expansion program? Why?