Lawn Depot, Inc
... = 7% (1 – 40%) = 4.2% As of this year, Lawn Depot has 310,000 bonds outstanding with a par value of $1000, remaining life of 15 years and coupon rate of 7%. The current rate of interest for 15-year bond with Lawn Depot’s rating is 8% per year. Similar to short-term debt, interest on bonds is also tax deductible, which brings the company’s cost of long-term debt to: kd lt = YTM (1 – Tax rate) = 8% (1 – 40%) = 4.8% Mr. Kresser mentioned to us that to satisfy its future capital requirements, the company can obtain additional long-term debt of up to $19.2 million at an interest rate of 8% through its line of credit agreement with its commercial bank. However, if Lawn Depot’s future capital requirements will exceed $19.2 million in long-term debt, the company will have to issue additional long-term debt at the interest rate of 12.5%. In this case, the cost of long-term debt will come up to: kd new lt = YTM (1 – Tax rate) = 12.5% (1 – 40%) = 7.5% b. Cost of Preferred Stock – Lawn Depot’s perpetual preferred stock has $100 par value and it is currently selling at par. It also pays $9 annual dividend. The cost of preferred stock is: k np = Dnp / Pnp = $9 / 100 = 9% If the company decides to issue new preferred stock then its cost of preferred stock, including floatation cost of 10%, will come to: k np = Dnp / Pnp = $9 / (100 – 10) = 10% c. Cost of Equity – At present, Lawn Depot has 8 million shares outstanding, and the stock is selling for $60 per share. To calculate the company’s cost of equity we will utilize Discounted Cash Flow Model. The company’s finance department had estimated that 1993 EPS will be $10. We also know that Lawn Depot’s historical payout ratio is 60%, making estimated dividends in 1993 equal to $6 per share. From the information provided by Mr. Kresser, we have calculated, using geometric mean technique, the company’s growth rate from 1983 to 1993: 10.05%. However, security analysts and investment bankers cast doubt that Lawn Depot will be able to sustain the growth rate of 10%. They say that in the current economic environment Lawn Depot will only be able to grow at half of the growth rate it had enjoyed from 1983 to 1993. Considering analysts comments in respect to Lawn Depot’s growth, we have determined the following cost of equity: ke = (D1 / P0) / g = ($6 / $60) + 5% = 15.03% If the company decides to issue additional common shares, then its cost of equity, including underwriting cost of $12 per share, will come to: ke = (D1 / P0) / g = ($6 / ($60 - $12)) + 5% = 17.53% The company’s cost of capital before raising additional capital is equal to: Fraction Cost Product Short-term 5% 4.20% 0.22% Long-term 30% 4.80% 1.42% Preferred stock 15% 9.00% 1.36% Retained earn 50% 15.03% 7.52% 100% ----- WACC = Ka = 10.53% The company’s cost of capital after raising additional capital is equal to: Fraction Cost Product Short-term 5% 4.20% 0.22% Long-term 30% 7.50% 2.22% Preferred stock 15% 10.00% 1.51% New CS 50% 17.53% 8.78% 100% ----- WACC = Ka = 12.73% 4. Please refer to Graph 1. Mr. Kresser had informed our team that he would like us to help him with evaluation of six new projects using MCC and IOS schedules (See Graph 1): Project IRR Group 1 15% Group 2 12% Group 3 10% A 18% A* 19.96% B 15% 5 a. If a good project becomes available, the company should respond by making adjustments to the IOS schedule. The IRR must be calculated for the new project with the cost of project, annual cash flows and estimated life data. Once we plot the new project in the IOS schedule, we can see where it lies in relation to the MCC schedule and see how attractive the project is and whether we should accept it or not. If it lies above the intersection point between the IOS and MCC schedule, we should accept the project. b. If the cost of capital changes causing the MCC schedule to be raised or lowered, the same concept applies to part (a.) above. We will have to see where the new intersection point is between t...