Optimal Capital Budget

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Business 441: In-class Example 7
Optimal Capital Budget

The following are some of the data related to Maness Mining Company (MMC):

1) Target capital structure: 40% debt, 10% preferred stock, and 50% equity. 2) Projected net income available to common stockholders for next year is $10 million, and the dividend payout ratio is 40%. Preferred stock consists of $10 million face value of 10% preferred. Depreciation for next year is expected to be$1 million. 3) The firm is a constant growth company with a current dividend of $2, a current market price of $20, and an annual growth rate of 5%. 4) The yield to investors is 12% on all new preferred stock. Floatation costs are 20% on all new common stock and 5% on all new preferred stock. 5) Cost of debt is 10% for up to $1 million of debt, and 14% for all debt over $1 million. 6) The firm’s federal and state tax rate is 40%.

7) The four projects listed below are being considered for next year’s capital budget:

|Project |Cost (Millions of $) |IRR | |A |$2.5 |12.0% | |B |5.0 |13.6% | |C |7.5 |15.0% | |D |2.5 |12.8% |

a. Plot the firm’s MCC schedule.
b. Plot the IOS schedule
c. Assuming that the projects are perfectly divisible and have average risk, what projects should the firm accept, and how large should its capital budget be? If any project is accepted in part, what percentage would be accepted? d. Assuming that the projects are nondivisible and have average risk, which project should be accepted, and what is the size of the optimal capital budget? e. Assume that Maness’s corporate cost of capital is 13%. The firm adjusts is corporate cost of...
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