Finance Project: Optimal Capital Structure, Cost Of Capital

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CASE STUDY SITUATION ClnCare Industries currently evaluating its capital structure. The review has been initiated by the board over concerns that the lack debtis artificially increasing the cost of capital firm resulting projects being accepted Currently he firm's c capital structure 80% common stock with the remainder preferred stock. The common stock currently pays dividend $2 10 and trades $14: the growth rate of the firmis generally estimated be 2% The preferred stock has price of $10 and pays $1 annually. The proposal being considered is to have anew capital structure that splits the commons stock component equally with debt that is, 40% common stock 40% debt, and 20% preferred stock this change made allo the securities issued by the firm the near future would bein the form bonds Research has determined that other debt this quality canbe issued 7% after flotation costs have been factored into the cost You have decided that the faires way to compare new rates would beto use the weighted average cost capital (WACC) using current proposed capital structure Although u know there other issues not being considered by the board (for example tax effects). you have been asked show only the effect mixing debt into the capital structure In addition tocalculating the cost capital you have been asked demonstrate the effect of the change ona typical list investment projects available the firm These projects are shown below. Project IRR Cost 9.00% 14,100 12.00% $500,000 16.00% 78,000 15.00% $ 51,000 $210,000 PERFORMANCE INDICATORS for Part Two Describe the firm under each scenario Identify capital canital Calculate under each scenario. Use which investn ents should be . Describe what the results you about the board's decision change the capital structure of the firm CASE STUDY SITUATION ClnCare Industries recently changedits capital structure from al equity to mix of debt and equity because was assumed the previous cost capital- estimated be 5.6%-was artificially high. The previous mix of capital was 80% common equity and 20% preferred stock: the new mix consists 40% common equity. 40% debt, and 20% preferred stock Although the entire board approved the change, was understood that there were several issues considered the time the change was made Inparticular the effect having issue new securities was factored into the cost capital, nor was any benefit calculated from the tax effecto issuing debt. n this presentation you have been asked address these concerns specifically. Currently the firm has stock that priced at $14 share this stock pays dividend of $2.10a year and currently growing ata rate 2% year addition the firm has preferred stock issued $10 share which they have been paying $1 dividends You have been assured that the firm can issue all the debt needs ata 7% rate including the flotation costs Additional information which you uneed consider includes flotation cost for new stock which estimated 10% the stock price and combined tax rate 30% applicable the 7% cost debt. The board has asked that this presentation include estimates for the following three scenarios 1. The WACC i: calculated assuming no new stock issued and there are notax benefits from issuing debt. 2. WACC is calculated assuming no new stock issued but there is a tax reduction due the use of 7% cost debt and: combined tax rate of 30% 3. The WACC calculated assuming both new stock and debt are issuedto finance projects and tax reduction the cost debt. In addition to calculating the cost capital for all three scenarios, you have beer asked to demonstrate the effect using each on typical list of investment projects available the firm These projects : are shown below Project IRR Cost 22.00% $122,000 9.00% 12.00% 1600% 78 000 15.00% 51,000 19.00% $210,000 G Optimal capital structure, cost of capital CInC Industries. Div Grow Flotation Current k Yield Div Price Cost Cost using retained earnings 17% 0.15 0.02 $2.10 14.00 NA Cost equity using new stock issue 0.17 0.02 $ 12.60 10% Cost of debt NA NA NA NA Included After tax cost of debt Preferred Stock 10% $ 1.00 10.00 Tax Rate 30% Project IRR Cost Ki weight A 22.00% $ 122,000 Cost of equity using retained earnings 9.00% Cost of debt Preferred Stock 16 00% 78 000 WACC assuming nonew equity and 0,0000 51,000 19.00% Ki weight G $ 241,000 Cost of equity using retained earnings After-t Costo debt Preferred Stock WACC assuming new equity and 0,0000 Ki weight Cost fequity After-tax Costo debt Preferred Stock WACC assuming new equity and 0.0000 Project A B C D E F G IRR Old WACC WACC assuming new equity and assuming no new equity WACC assuming new equity and

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Finance Project: Optimal Capital Structure, Cost Of Capital
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