Pickerington Communications Inc. (PCI) has developed a powerful server that would be used for the company’s internet activities. The company has the following capital structure, which is considered optimal. Debt is 30%, preferred stock is 10%, and common stock is 60%. PCI’s tax rate is 25%, and investors expect earnings and dividends to grow at a constant rate of 6% in the future. The company paid a dividend of $3.70 per share last year (D0), and its stock currently sells at a price of $60 per share. Ten-year Treasury bonds yield 6%, the market risk premium is 5%, and PCI’s beta is 1.3.
The following information is available for managerial finance analysis:
Preferred stock: New preferred stock could be sold to the public at a price of $100 per share, with a dividend of $9. Flotation costs per share is $5.
Debt: The company’s long-term debt has a yield to maturity of 9%.
Common stock: All common stock will be raised internally by reinvesting earnings.
a. Calculate the company’s after-tax cost of debt.
b. Calculate the cost of preferred stock.
c. Calculate the company’s cost of common stock using both CAPM method and the dividend growth method.
d. What is the company’s weighted average cost of capital (WACC)?
The company’s management is meeting today to discuss ways to minimize its cost of capital.
e. Identify three factors that the management of PCI cannot control and three factors that it can use to control its cost of capital.
Another company, Davis Industries is choosing between a gas-powered and an electric-powered forklift truck for moving materials in its factory. Because both forklifts perform the same function, the firm will choose only one i.e., they are mutually exclusive investments. The cost of capital is 10%. The director of capital budgeting has provided the expected cash flows of the machines as follows:
Expected Net Cash Flows
Year
Machine A
Machine B
0
($50,000)
($50,000)
1
25,000
15,000
2
20,000
15,000
3
10,000
15,000
4
5,000
15,000
5
5,000
15,000
f. Calculate the payback period and profitability index for each machine.
g. Calculate net present value (NPV) and internal rate of return (IRR) for each machine.
h. Using the NPV technique, which machine should be recommended?
The director of capital budgeting has asked you to include risk analysis in your report. He wants you to explain risk in the context of capital budgeting, and how the risk can be analyzed.
i. Explain three types of risk that are relevant in capital budgeting decisions.
j. How is each of these risk types measured?