Page 197 - DMGT521_PROJECT_MANAGEMENT

Project Management

Notes at 11% before-tax cost, the next $1,800,000 will cost 12%, and all debt after $3,600,000 will cost
13%. If STN issues new common stock, a 12% underwriting cost will be incurred. STN can sell the
first $200,000 of new common stock at the current market price, but to sell any additional new
stock, STN must lower the price to $14. STN is at its optimal capital structure, which is 60% debt
and 40% equity, and the firm’s marginal federal-plus-state tax rate is 40%. STN has the following
independent, indivisible, and equally risky investment opportunities:

Table 11.2: Investment Opportunities Available to STN

Project Cost IRR (%)
A $3,200,000 13.0
B 1,300,000 10.7
C 1,750,000 12.0
D 450,000 11.2

What is STN’s optimal capital budget?

The first thing we need to determine is STN’s MCC schedule. In order to do that, we will follow
the three-step procedure. First, we will identify the different break points in the MCC schedule.
In this scenario, there will be 4 break points in the MCC schedule.

Break Point 1: When the firm exhausts its retained earnings and issues new common stocks.
We will let T represents the total amount of capital STN can raise without
1
exhausting its retained earnings. We know that STN is expecting a net income
of $2,700,000 and it is planning on retaining 70% of it (since the payout ratio is
30%). As a result, we know the following:
Retained earnings = 0.7 × 2,700,000 = $1,890,000

Since we know 40% of T comes from the retained earnings, it is true that:
1
1,890,000
0.4 × T = 1,890,000 T = = $4,725,000
1 1 0.4
From the above calculation, we know STN can raise up to $4,725,000 in capital
without exhausting its retained earnings.
Break Point 2: When STN has to go from issuing 11% debt to issuing 12% debt.

We know STN can raise a total of $1,800,000 with 11% debt. We will let be the
total amount of capital STN can raise with the help of issuing 11% debt. Since
STN raises its capital with 60% debt, we know the following:

1,800,000
0.6 × T = 1,800,000 T = = $3,000,000
2 2 0.6
STN can raise up to $3,000,000 in capital with the help of issuing only 11%
debt.
Break Point 3: When STN has to go from issuing 12% debt to issuing 13% debt.
We know STN can raise the first $1,800,000 with 11% debt and the next $1,800,000
with $12% debt. In other words, STN can raise a total of $3,600,000 using only
11% and 12% debt. We will let T represents the maximum amount of capital
3

192 LOVELY PROFESSIONAL UNIVERSITY