Question 1 (22 marks)

Rick Limited is trying to calculate its cost of capital for use in a capital budgeting decision. The CFO has given you the following information and has asked you to compute the weighted average cost of capital (WACC).

Debts (Bonds only) The company currently has outstanding a bond (Bond A) with a 12.2% coupon rate and another bond (Bond B) with a 9.5% coupon rate. The company has been informed by its investment banker that bonds of equal risk and credit rating are now selling to yield 13.8%. The total book value of Bond A and B is $550,000,000, and the total market value is $340,000,000.

Common stock The company has 9,200,000 common stock outstanding, and each has a par value of $35. The current market value of the common stock is $130 per share and it has just paid dividend of $12 per share. The firms historical growth rate of earnings and dividends per share has been 9.5%, but security analysts on Wall Street expect this growth to slow to 6.5% in coming year and the future years.

Preferred stock The company has 530,000 preferred stock outstanding, and each has a par value of $100 with 14.5% dividend rate on par value. The preferred stock is currently trading at $115 per share on stock exchange.

Additional information

1. The company is subject to 35% corporate tax rate.

2. The company will maintain the current optimal capital structure, based on the respective source of capitals current market value.

Required:

1. Calculate the cost of debt, cost of common stock and cost of preferred stock. (10 marks)

2. Calculate the respective percentage of debt, common stock and preferred stock to Rick Limiteds current optimal capital structure. (8 marks)

3. Calculate Rick Limiteds WACC. (4 marks)

Question 2 (28 marks)

Disk City, Inc. is a retailer for digital video disks. The projected net income for the current year is $200,000 based on a projected sales volume of 200,000 video disks. Disk City has been selling the disks for $16 each. The variable costs consist of the $10 unit purchase price of the disks and a handling cost of $2 per disk. Disk Citys annual fixed costs are $600,000.

Management is planning for the coming year, when it expects that the unit purchase price of the video disks will increase 30 percent. (Ignore income taxes.)

Required:

1. Calculate Disk Citys break-even point for the current year in number of video disks and in dollars. (8 marks)

2. Prepare a CVP graph showing cost and revenue data for Disk City. Please show all the necessary information. The CVP graph does not need to be on scale. (8 marks)

3. What will be the companys net income for the current year if there is a 10 percent increase in projected unit sales volume? (6 marks)

4. What volume of sales (in dollars) must Disk City achieve in the coming year to maintain the same net income as projected for the current year if the unit selling price remains at $16? (6 marks)