Question

The capital structure of the Valley Products Company is as shown below, on April 30, 2019.

PROBLEM 4 The capital structure of the Valley Products Company is as shown below, on April 30, 2019. Long term Debt (8%) $ 128,000,000 Common Stockholders equity (8 million shares) 192,000,000 $ 320,000,000 The company believes this capital structure to be optimal and therefore desires to maintain it. That is, DO NOT CHANGE IT. The company estimates next years net income, NII, will be $48 million. Its payout ratio is expected to remain at 25 percent. New bonds will have a 10 percent coupon rate and will be sold at par. However, investment bankers agree that if Valley sells more than $30,000,000 in bonds, the cost of debt for the entire issue will rise to 13 percent. The required rate of return on common stock, rs, is 15.0%, but due to flotation cost, the firm must earn 18.0% on its new common stock, r. The firm's marginal tax rate is 40 percent. 4a) The firm wishes to maintain its current capital structure. If the capital budget for Valley Products is $67.5 million, will the firm use the cheaper 10 percent or the more expensive 13 percent debt in the capital budget? Support your answer. 4b. Remember, the firm wishes to maintain its current capital structure. If the capital budget for Valley Products is S67.5 million, will the firm use retained earnings or new common stock as the equity financing component in the capital budget? Support your answer. 4c. What is the cost of capital for Valley Products if its capital budget equals S67.5 million? Remember that the firm wishes to maintain its current capital structure. The firm's marginal tax rate is 40%.

Answer 1

Answer 4a - The current Debt - equity ratio is 0.67 ($128,000,000 / $192,000,000)

                   Next years company's income will be $ 48 Million

                   Net income after tax will be $28.8 million [(48 (1-0.4)]

                   Then dividend payout on above income @ 25% will be $7.2 million and retained earnings will be $ 21.6 million

                   then total equity will be $ 213,600,000. Now to maintain the debt equity ratio same as was in last year company    will have to issue long term debt for $ 15.112 million. then total debt will equal to $143.12 million.

Therefore firm have to use cheaper (10%) debt in the capital budget as amount of of debt to be raised is $15.112 million which is less than $30 million

Ans 4b - If the capital budget of Valley product is $67.5 million then to maintain the capital structure it will use retained earnings of $21.6 million and common sock of $45.9 million

Ans 4c - Firms cost of capital will be as follows if its capital budget is $67.5 million :

             [(213.6 m / 356.72) * 25%] + [143.12 m / 356.72] * 6% (cost of debt net of tax is taken)

            = 14.97% + 2.41% = 17.38%