Ace Products Company is a growing manufacturer of automobile accessories whose stock is
actively traded on the over-the-counter (OTC) market. During 2009, the Dallas-based
company experienced sharp increases in both sales and earnings. Because of this recent growth, Kaka, the company`s treasurer, wants to make sure that available funds are being
used to their fullest. Management policy is to maintain the current capital structure
proportions of 30% long-term debt, 10% preferred stock, and 60% common stock equity for
at least the next 3 years. The firm is in the 40% tax bracket.
Ace`s division and product managers have presented several competing investment
opportunities to Jen. However, because funds are limited, choices of which projects to accept
must be made. The investment opportunities schedule (IOS) is shown below.
Investment Opportunities Schedule (IOS) for Star Products Company
Internal rate of return (IRR)
To estimate the firm`s weighted average cost of capital (WACC), Kaka contacted a leading
investment banking firm, which provided the financing cost data shown in the following
Financing Cost Data Ace Products Company
Long-term debt: The firm can raise $450,000 of additional debt by selling 15-year, $1,000-
par-value, 9% coupon interest rate bonds that pay annual interest. It expects to net $960 per
bond after flotation costs. Any debt in excess of $450,000 will have a before-tax cost, rd, of
Preferred stock: Preferred stock, regardless of the amount sold, can be issued with a $70 par
value and a 14% annual dividend rate and will net $65 per share after flotation costs.
Common stock equity: The firm expects dividends and earnings per share to be $0.96 and
$3.20, respectively, in 2010 and to continue to grow at a constant rate of 11% per year. The
firm`s stock currently sells for $12 per share. Expects to have $1,500,000 of retained earnings
available in the coming year. Once the retained earnings have been exhausted, the firm can
raise additional funds by selling new common stock, netting $9 per share after underpricing
and floatation costs.
a. Calculate the cost of each source of financing, as specified:
(1) Long- term debt, first $450,000.
The cost of debt is the after tax YTM. YTM is the discounting rate that will make the present
value of interest and principal equal to the price today. We use the RATE function to calculate the YTM
The formula is
Price = Annual interest X PVIFA (period, rate) + Par value X PVIF (period, rate)
After tax cost of debt
After tax cost = Before tax cost X (1-tax rate)
(2) Long- term debt, greater than $450,000.
For debt greater than $450,000 the before tax cost would be 13%
Before tax cost
After tax cost
(3) Preferred stock, all amounts.
Preferred stock is a perpetuity and the cost is given as Annual dividend/Price
Cost = Annual dividend/price
Cost of preferred stock
(4) Common stock equity, first $1,500,000.
Retained earning cost is the cost of internal...
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