Question
Rolodex, Inc. is in the process of determining its capital budget for the next fiscal year. The firms current capital structure, which it considers to
Rolodex, Inc. is in the process of determining its capital budget for the next fiscal year. The firms current capital structure, which it considers to be optimal, is contained in the following balance sheet:
Rolodex, Inc. Balance Sheet (in millions of $)
Current assets $110 Accounts payable $30
Fixed assets 260 Other current liabilities 20
Total assets $370 Long-term debt 128
. Preferred stock 32
. Common stock (20 million shares) 50
. Retained earnings 110
. Total liabilities & equity $370
Discussions between the firms financial officers and the firms investment and commercial bankers yielded the following information:
Debt: Rolodex can borrow $40 million from its bank at a pre-tax cost of 13%. After using up its bank loans, Rolodex can borrow $80 million by issuing bonds at a net price of $687 per bond. The bonds would carry a 10% coupon rate (paying its interest twice a year) and mature in 20 years. Additional bond can be issued at a pre-tax cost of 16%.
Preferred: Preferred stock can be issued at a pre-tax cost of 16.5%.
Equity: Rolodex can generate $140 million in net income and pay $2 per share in dividends. The $2 per share dividend (D1) represents a growth of 5.5% over the previous years dividend. This growth rate is expected to continue for the foreseeable future. The firms stock is currently trading at $16 per share. Rolodex can raise external equity by selling common stock at a net price of $15 per share.
Tax: Rolodexs marginal tax rate is 40%.
The following are the available investment opportunities (all projects are non-divisible):
Project Required Investment IRR
A $24,000,000 13.0%
B $100,000,000 15.2%
C $16,000,000 10.9%
D $80,000,000 14.2%
E $130,000,000 16.0%
F $140,000,000 17.0%
a. Plot Rolodexs marginal cost of capital schedule. Show your work.
b. Plot Rolodexs investment opportunity schedule.
c. Determine Rolodexs optimal capital budget and its marginal cost of capital.
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