Group Project 2 Question 6

Group Project 2 Question 6

1. The following capital structure is taken from Bata Boots Co. balance sheet for the fiscal year ended April 30, 2005. This is considered the firm’s optimal capital structure.
   Mortgage Bonds (due 2020) $16,000,000
   Debentures (due 2006) 12,000,000
   Preferred Share "A" (dividend 12%) 12,000,000
   Preferred Share "B" (dividend $1.80) 4,000,000
   Common Shares (3,600,000 outstanding) 8,000,000
   Retained Earnings28,000,000
   Total Capital $80,000,000
   For the 2006 fiscal year, Bata Boots is evaluating three independent investment opportunities. The first (Asset A) costs $9 million and is expected to provide a 14% rate of return. The second (Asset B) costs $11.5 million and is expected to provide a 16.8% rate of return. The third (Asset C) costs $17 million and is expected to provide a 13.4% rate of return.
   The firm's president, Boots Bailey, wonders which of the three investment opportunities the firm should proceed with. He has been informed that determining the firm's after-tax cost of capital is the first step in making this decision. Boots has approached you with the following information to see if you can help him with his problem.
   The company's common shares have been trading on the Toronto Stock Exchange for the past 28 years; the current price is $17.50 per share. EPS for the previous 10 years is provided below. Boots has suggested that the past ten years is not a representative time period to estimate future growth. Boots expects future growth will be only 75% of that experienced over the past 10 years.
   

Year / EPS / Year / EPS
1996 / $0.34 / 2001 / $0.85
1997 / 0.41 / 2002 / 1.02
1998 / 0.50 / 2003 / 1.22
1999 / 0.59 / 2004 / 1.46
2000 / 0.71 / 2005 / 1.75

Bata attempts to maintain a common share dividend pay-out ratio of 40%. A recent discussion with their underwriters, Revell & Co., indicates that if Boots issued additional common shares, the discount to the current price would be 8%. In addition, underwriting fees would be $2.10 per share.

The company sold the "A" preferred share issue in 1981 and they currently trade for $31.58. The "B" issue of preferred were sold in 1985 and they currently trade for $18.95. Both preferred have $25 stated values. Revell & Co. has informed Boots that a new issue of preferred shares would require underwriting fees of 5% of the stated value.

The debentures were issued in March 1986, for par, with a coupon rate of 5.5% paid semi-annually. They are rated BB and are quoted at 75.07. Revell & Co. has informed Boots that the market will only purchase a five-year debenture from Bata Boots. Debentures rated BB with 5 years to maturity are currently trading to yield 11.79%. The underwriting fees associated with a issue of five-year debentures for Bata would be 2.1% of par and the debentures would sell at a discount of 1.2% of par.

The 20 year mortgage bonds were issued five years ago with a coupon rate of 14%, paid semiannually. They are now quoted at 118.8. If Bata issued new 20-year mortgage bonds, the company would have to pay a premium of 29 basis points above the yield on the mortgage bonds currently outstanding. When sold, the underwriting fees on the new bonds would be 1.8% of par.

Considering the choice of projects given at the beginning of this problem, which project(s) would you recommend Bata Boots Co. accept? Fully explain. Bata’s tax rate is 40%. XXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXIndividual Assignment

9–10Cost of reinvested profits versus new common shares—DVM Using the data for each firm shown in the following table, calculate the cost of reinvested profits and the cost of new common shares using the constant-growth DVM.

9–4Cost of debtFor each of the following bonds, calculate the after-tax cost of debt. Assume the coupons are paid semi-annually, that the tax rate is 40 percent, and that we are dealing with $1,000 of par value.

9–21WACC, MCC, and IOSCartwell Products has compiled the data shown in the following table for the current costs of its three sources of capital—long-term debt, preferred equity, and common equity—for various ranges of new financing.

The company’s optimal capital structure, which is used to calculate the weighted average cost of capital, is shown in the following table.

a.Determine the break points and ranges of new financing associated with each source of capital. At what financing levels will Cartwell’s weighted average cost of capital change?

b.Calculate the weighted average cost of capital for each range of total new financing found in a. (Hint: There are three ranges.)

c.Using the results of b along with the following information on the available investment opportunities, draw the firm’s marginal cost of capital (MCC) schedule and investment opportunities schedule (IOS).

d.Which, if any, of the available investments do you recommend that the firmselect? Explain your answer.

e.Now calculate the overall cost of capital for Cartwell Products. Which projects should the firm select? Does your answer differ from your answer topart d? If so, explain why.

9–6Cost of preferred equity Taylor Systems has just issued preferred shares. The shares have a 12 percent annual dividend and a $100 stated value and were sold at $97.50 per share. In addition, flotation costs of $2.50 per share must be paid.

a.Calculate the cost of the preferred shares. What is the after-tax cost of the preferred shares?

b.If the firm sells the preferred stock with a 10 percent annual dividend and nets $90 after flotation costs, what is its cost?

(Hennessey 539

Hennessey, Lawrence J. Gitman and Sean M..Principles of Corporate Finance VitalSource eBook for Athabasca University.Pearson Learning Solutions.vbk:9781256458005#outline(12.10)>.