Question 4:

Natural Convenience has a range of new investment opportunities currently available, due to new land developments in South Australia. As a result, Natural Convenience must determine the cost of capital to be applied in their capital budgeting process.

The management policy for the foreseeable future is to maintain the firms current target capital structure of 42% long-term debt, 5% preferred stock, and 53% common equity. Natural Conveniences marginal tax rate is 30%.

The firm can raise $56 million of debt capital by selling 4.5% coupon mortgage bonds, each with 12 years till maturity and par values of $1,000. These mortgage bonds are expected to net the firm $995 per bond after issuance costs. Beyond $56 million, the firm would be able to raise additional debt capital by selling debentures at an after-tax cost that is 1.5% higher than the after-tax cost of their mortgage bonds.

Natural Convenience is also able to issue a maximum amount of $14 million of preferred stock. These preferred stocks will pay a $1.30 dividend each and are believed to net the firm $18.50 each after flotation costs.

The firms common stock is currently trading at $16 per share. Natural Convenience expects to pay a dividend of $0.85 per share next year to all common stockholders, with dividends expected to increase each year by 5% into perpetuity. The firm expects to have $106 million in retained earnings available in the coming year. Once retained earnings are exhausted, the firm can raise an unlimited amount of additional equity capital by selling new common stocks. These new shares of common stock will be sold to investors at $15 per share and will cost the firm $1 per share in issuance costs.

1. Calculate the breakpoints associated with each source of capital.
2. Compute Natural Conveniences marginal cost of capital schedule.