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Chapter 4: Q27BP (page 369)

Question: Delta Corporation has the following capital structure:

Cost (after tax)

Weights

Weighted cost

Debt

8.1%

35%

2.84

Preferred stock (Kp)

9.6

5

0.48

Common equity (Ke) (retained earnings)

10.1

60

6.06

Weighted average cost of capital (Ka)

9.38%

a. If the firm has \(18 million in retained earnings, at what size capital structure will the firm run out of retained earnings?

b. The 8.1 percent cost of debt referred to earlier applies only to the first \)14 million of debt. After that the cost of debt will go up. At what size capital structure will there be a change in the cost of debt?

Short Answer

Expert verified

Answer

  1. $30 million.
  2. $40 million.

Step by step solution

01

Definition of Retained Earnings

The income of the business entity that is kept aside for re-investment in the business entity or to make dividend payments in future periods is known as retained earnings.

02

Calculation of capital structure at which the firm will run out of retained earnings

The weight of the common equity represents the retained earnings in the capital structure, which is 60% of the total capital structure. Therefore, the size of the capital structure at which the firm will run out of retained earnings is calculated as:

Y=RetainedearningsWeightageofcommonequity=$1860%=$30million

03

Capital structure at which there is a change in the cost of debt

The cost of debt only applied to the first $14 million. Therefore, the capital structure at which the cost of debt will change will be calculated as follows:

Z=DebtWeightageofDebt=$1435%=$40million

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Most popular questions from this chapter

What are the basic benefits and purposes of developing pro forma statements and a cash budget?

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Question:Surgical Supplies Corporation paid a dividend of $1.12 per share over the last 12 months. The dividend is expected to grow at a rate of 2.5 percent over the next three years (supernormal growth). It will then grow at a normal, constant rate of 7 percent for the foreseeable future. The required rate of return is 12 percent (this will also serve as the discount rate).

a. Compute the anticipated value of the dividends for the next three years (D1, D2, and D3).

b. Discount each of these dividends back to the present at a discount rate of 12 percent and then sum them.

c. Compute the price of the stock at the end of the third year (P3).

P3 = D4/ (Ke - g)

d. After you have computed P3, discount it back to the present at a discount rate of 12 percent for three years.

e. Add together the answers in part b and part d to get the current value of the stock. (This answer represents the present value of the first three periods of dividends plus the present value of the price of the stock after three periods.)

Jack Hammer invests in a stock that will pay dividends of \(2.00 at the end of the first year; \)2.20 at the end of the second year; and \(2.40 at the end of the third year. Also, he believes that at the end of the third year he will be able to sell the stock for \)33. What is the present value of all future benefits if a discount rate of 11 percent is applied? (Round all values to two places to the right of the decimal point.)
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