Marginal cost of capital breakpoint

Please use this answer as solution guide. Reword the answer.

Integrative Case 4: O’Grady Apparel Company

O’Grady Apparel Company was founded nearly 160 years ago when an Irish merchant named Garrett O’Grady landed in Los Angeles with an inventory of heavy canvas, which he hoped to sell for tents and wagon covers to miners headed for the California goldfields. Instead, he turned to the sale of harder- wearing clothing. Today, O’Grady Apparel Company is a small manufacturer of fabrics and clothing whose stock is traded on the over- the-counter exchange. In 2012, the Los Angeles– based company experienced sharp increases in both domestic and European markets resulting in record earnings. Sales rose from $ 15.9 million in 2011 to $ 18.3 million in 2012 with earnings per share of $ 3.28 and $ 3.84, respectively. European sales represented 29% of total sales in 2012, up from 24% the year before and only 3% in 2001, 1 year after foreign operations were launched. Although foreign sales represent nearly one- third of total sales, the growth in the domestic market is expected to affect the company most markedly. Management expects sales to surpass $ 21 million in 2013, and earnings per share are expected to rise to $ 4.40. ( Selected income statement items are presented in Table 1.)

Table 1. Selected Income Statement Items

2010 2011 2012 Projected 2013

Net sales $ 13,860,000 $ 15,940,000 $ 18,330,000 $ 21,080,000

Net profits after taxes 1,520,000 1,750,000 2,020,000 2,323,000

Earnings per share ( EPS) 2.88 3.28 3.84 4.40

Dividends per share 1.15 1.31 1.54 1.76

Because of the recent growth, Margaret Jennings, the corporate treasurer, is concerned that available funds are not being used to their fullest potential. The projected $ 1,300,000 of internally generated 2013 funds is expected to be insufficient to meet the company’s expansion needs. Management has set a policy of maintaining the current capital structure proportions of 25% long- term debt, 10% preferred stock, and 65% common stock equity for at least the next 3 years. In addition, it plans to continue paying out 40% of its earnings as dividends. Total capital expenditures are yet to be determined.

Jennings has been presented with several competing investment opportunities by division and product managers. However, because funds are limited, choices of which projects to accept must be made. The investment opportunities schedule ( IOS) is shown in Table 2. To analyze the effect of the increased financing requirements on the weighted average cost of capital ( WACC), Jennings contacted a leading investment banking firm that provided the financing cost data given in Table 3. O’Grady is in the 40% tax bracket.

Investment Opportunities Schedule ( IOS)

Investment opportunity Internal rate of return ( IRR) Initial investment

A 21% $ 400,000

B 19 200,000

C 24 700,000

D 27 500,000

E 18 300,000

F 22 600,000

G 17 500,000

Financing Cost Data Long- term debt: The firm can raise $ 700,000 of additional debt by selling 10- year, $ 1,000, 12% annual interest rate bonds to net $ 970 after flotation costs. Any debt in excess of $ 700,000 will have a before- tax cost, kd, of 18%.

Preferred stock: Preferred stock, regardless of the amount sold, can be issued with a $ 60 par value and a 17% annual dividend rate. It will net $ 57 per share after flotation costs.

Common stock equity: The firm expects its dividends and earnings to continue to grow at a constant rate of 15% per year. The firm’s stock is currently selling for $ 20 per share. The firm expects to have $ 1,300,000 of available retained earnings. Once the retained earnings has been exhausted, the firm can raise additional funds by selling new common stock, netting $ 16 per share after under- pricing and flotation costs.

1. Over the relevant ranges noted in the following table, calculate the after- tax cost of each source of financing needed to complete the table.

Source of capital Range of new financing After- tax cost (%)

Long- term debt $ 0–$ 700,000 ___

$ 700,000 and above ___

Preferred stock $ 0 and above ___

Common stock equity $ 0–$ 1,300,000 ___

$ 1,300,000 and above ___

2. a. Determine the break points associated with each source of capital. b. Using the break points developed in part ( 1), determine each of the ranges of total new financing over which the firm’s weighted average cost of capital ( WACC) remains constant. c. Calculate the weighted average cost of capital for each range of total new financing.

3. a. Using your findings in part b( 3) with the investment opportunities schedule ( IOS), draw the firm’s weighted marginal cost of capital ( WMCC) schedule and the IOS on the same set of axes, with total new financing or investment on the x axis and weighted average cost of capital and IRR on the y axis. b. Which, if any, of the available investments would you recommend that the firm accept? Explain your answer.

4. a. Assuming that the specific financing costs do not change, what effect would a shift to a more highly leveraged capital structure consisting of 50% long- term debt, 10% preferred stock, and 40% common stock have on your previous findings? ( Note: Rework parts b and c using these capital structure weights.) b. Which capital structure— the original one or this one— seems better? Why?

5. a. What type of dividend policy does the firm appear to employ? Does it seem appropriate given the firm’s recent growth in sales and profits and given its current investment opportunities? b. Would you recommend an alternative dividend policy? Explain. How would this policy affect the investments recommended in part c( 2)?

O’Grady Apparel Company

(a) Cost of financing sources

Debt:

$0 – $700,000
ki  kd(1 – t)

ki  0.125(1 – 0.4)

ki  0.075 or 7.5%

Above $700,000: kj  0.18(1 – t)

kj  0.18(1 – 0.4)

kj  0.108 or 10.8%

Preferred Stock:
Common Stock Equity:

$0 – $1,300,000
Above $1,300,000
(b) (1) Breaking Points: BPj  AFj Wj

Preferred stock: Not applicable

(2)

Cost of Component Source of Financing

Ranges of Total New financing

Long-term Debt

Preferred Stock

Common Stock Equity

$0–$2,000,000

7.5%

17.9%

23.8%

$2,000,001–$2,800,000

7.5%

17.9%

26.0%

Above $2,800,000

10.8%

17.9%

26.0%

(3) Weighted average cost of capital: ka  (wjkj)  (wpkp)  (wskr or n)

Range

Calculation

WACC

$0–$2,000,000

(0.250.075)  (0.100.179)  (0.65238)

 0.191 or 19.1%

$2,000,001–$2,800,000

(0.250.075)  (0.100.179)  (0.65.260)

 0.206 or 20.6%

Above $2,800,000

(0.250.108)  (0.100.179)  (0.65.260)

 0.217 or 21.4%

( IOS and WMCC )(c)

( Total New Financing/Investment ($000) ) ( Weighted Average Cost of Capital and IRR (%) )
(2) Projects D, C, F, and A should be accepted since each has an internal rate of return greater than the weighted average cost of capital.

(d) (1) Changing the capital structure to include more debt while keeping the cost of each financing source the same will change both the breaking points at which the weighted average cost of capital changes and the WACC.

Breaking points for 50% debt, 10% preferred stock, and 40% common stock:

WACC for new capital structure:

Range

Calculation

WACC

$0–$1,400,000

(0.500.075)  (0.100.179)  (0.400.238)

 0.151 or 15.1%

$1,400,001–$3,250,000

(0.500.108)  (0.100.179)  (0.400.238)

 0.167 or 16.7%

Above $3,250,000

(0.500.108)  (0.100.179)  (0.400.260)

 0.176 or 17.6%

Since the total for all investment opportunities is $3,200,000, the lowest IRR is 17%, and the cost of capital below $3,250,000 is less than 17% (15.1% and 16.7%), all 7 projects are acceptable.

(2) For any set of investment opportunities, the more highly leveraged capital structure will result in accepting more projects. However, a more highly leveraged capital structure increases the firm’s financial risk.

(e) (1) O’Grady follows a constant-payout-ratio dividend policy. For each of the years 2010 through 2012 the firm paid out a constant 40% of earnings. The same payout percent is included in the projections for 2013. Given the firm’s growth in sales and earnings it would seem appropriate to not continue the constant payout. O’Grady’s could use the internally generated funds to help finance some of the growth.

(2) They should change their dividend policy to the regular dividend policy. They can maintain the constant dividend as earnings increase, freeing up some cash for investment. If earnings continue to increase the constant dividend policy could later be converted to a low-regular-and-extra dividend policy. Retaining more of the income will increase the breakpoint for common stock equity financing. This higher breakpoint will cause a shift downward in the WMCC schedule. O’Grady’s should be able to undertake additional investment opportunities and further increase shareholders’ wealth.

p

$10.20

k17.9%

$57.00

==

1

s

0

D

kg

P

=+

s

$1.76

k0.1523.8%

$20.00

=+=

1

s

n

D

kg

N

=+

s

$1.76

k0.1526%

$16.00

=+=

$700,000

Long-term debt$2,800,000

0.25

==

$1,300,000

Common stock equity$2,000,000

0.65

==

16

18

20

22

24

26

28

0

500

1000

1500

2000

2500

3000

3500

WMCC

IOS

D

C

F

A

B

E

G

Sheet:

Financing

IOS

WMCC

$700,000

Long-term debt $1,400,000

0.50

==

$1,300,000

Common stock equity $3,250,000

0.40

==

d

d

d

$1,000N

I

n

k

N$1,000

2

-

+

=

+

d

$1,000$970

$120

$123

10

k12.5%

$970$1,000

$985

2

-

+

===

+

p

p

p

D

k

N

=