Medical Research Corporation Is Expanding Its Research
Medical Research Corporation Is Expanding Its Research And Production
Medical Research Corporation is expanding its research and production capacity to introduce a new line of products. Current plans call for the expenditure of $100 million on four projects of equal size ($25 million each), but different returns. Project A is in blood clotting proteins and has an expected return of 18 percent. Project B relates to a hepatitis vaccine and carries a potential return of 14 percent. Project C, dealing with a cardiovascular compound, is expected to earn 11.8 percent, and Project D, an investment in orthopedic implants, is expected to show a 10.9 percent return. The firm has $24,000,000 in retained earnings. After a capital structure with $24,000,000 in retained earnings is reached (in which retained earnings represent 60 percent of the financing), all additional equity financing must come in the form of new common stock. Common stock is selling for $26 per share and underwriting costs are estimated at $2.8 if new shares are issued. Dividends for the next year will be $0.31 per share (D1), and earnings and dividends have grown consistently at 11% per year. The yield on comparative bonds has been hovering at 10 percent. The investment banker feels that the first $20,000,000 of bonds could be sold to yield 10 percent while additional debt might require a 2 percent premium and be sold to yield 12 percent. The corporate tax rate is 30 percent. Debt represents 40 percent of the capital structure.
Paper For Above instruction
Introduction
The expansion plans of Medical Research Corporation necessitate a comprehensive analysis of its capital structure to determine optimal financing strategies and associated costs. This analysis encompasses the calculation of the initial weighted average cost of capital (WACC), understanding how retained earnings limit the firm’s growth, and assessing how shifts in capital structure influence the marginal cost of capital and debt costs. These financial considerations are essential for making informed investment and financing decisions aligned with the company's growth objectives.
Initial Weighted Average Cost of Capital (WACC)
The weighted average cost of capital represents a firm's average rate of return required by all its investors, incorporating the cost of debt and equity. Given the firm's current and projected financing sources, the calculation begins with identifying the cost of debt (Kd) and equity (Ke).
The firm can issue bonds in two tranches: the first $20 million at a yield of 10%, and additional debt at a yield of 12% to account for a 2% premium. Since debt entails interest expenses deductible for tax purposes, the after-tax cost of debt is calculated as:
- For the first $20 million:
\[
Kd_1 = 10\% \times (1 - 0.30) = 7\%
\]
- For additional debt:
\[
Kd_2 = 12\% \times (1 - 0.30) = 8.4\%
\]
Given the debt size is 40% of the total capital structure, proportionally allocating the debt yields an average after-tax cost of debt:
\[
K_d = (0.5 \times 7\%) + (0.5 \times 8.4\%) = 3.5\% + 4.2\% = 7.7\%
\]
The cost of equity (Ke) is derived through the Gordon Growth Model, considering the expected dividend next year ($0.31), the current stock price ($26), and growth rate (11%):
\[
Ke = \frac{D_1}{P_0} + g = \frac{0.31}{26} + 0.11 \approx 0.01192 + 0.11 = 0.12192 \text{ or } 12.19\%
\]
Finally, the WACC is computed as:
\[
WACC = (D / V) \times K_d + (E / V) \times K_e
\]
where:
- \(D / V = 0.4\),
- \(E / V = 0.6\),
Plugging in the values:
\[
WACC = 0.4 \times 7.7\% + 0.6 \times 12.19\% = 3.08\% + 7.31\% = 10.39\%
\]
Answer: The initial WACC is approximately 10.39%.
Capital Limitations from Retained Earnings
The firm has $24 million in retained earnings, which, according to the problem, constitutes 60% of its financing. Therefore, the total amount of internal financing (retained earnings) can support:
\[
Total\, Capital = \frac{Retained\, Earnings}{0.60} = \frac{24,000,000}{0.60} = 40,000,000
\]
Since the current retained earnings of $24 million suffice to fund part of the $100 million investment, the remaining portion must be financed through new equity and debt. The research projects' total expenditure ($100 million) exceeds internal funds, so the company needs external financing:
Remaining externally financed Capital:
\[
100,000,000 - 24,000,000 = 76,000,000
\]
The magnitude of retained earnings limits the firm's capacity, and the firm’s internal funding can support projects up to:
\[
\text{Maximum supported by retained earnings} = 40,000,000
\]
Thus, the firm can finance approximately $40 million using retained earnings, leaving $60 million to be raised externally.
Marginal Cost of Capital After Exhausting Retained Earnings
Once the retained earnings are exhausted, the firm must seek external financing at the given costs. The first $20 million of bonds can be issued at an after-tax yield of 10%; additional debt would cost 12% before taxes, leading to an after-tax cost of 8.4%. This results in an overall blended cost of debt of:
\[
Kd_{new} = \frac{(20\, \text{million} \times 7\%) + (remaining\, debt \times 8.4\%)}{\text{total debt}}
\]
Assuming the remaining debt is proportionally split, for simplicity, the marginal cost immediately after internal funds are exhausted would be approximately 8.4% (the higher cost of debt).
The cost of equity remains at 12.19%, but as capital more reliant on external sources is raised, the company's weighted cost of capital could increase due to higher debt costs and potential equity dilution.
Change in Cost of Debt and Its Impact
The cost of debt will change at the point when the company issues additional debt beyond the initial $20 million at favorable rates. Once the $20 million threshold is crossed, subsequent debt will cost 12%, pre-tax, or 8.4% after-tax, representing a significant step up in debt financing costs.
To find the total debt level at that point:
\[
\text{Total debt} = 0.4 \times \text{Total capital}
\]
As the total capital approaches the amount where the new debt costs 12%, the firm would have issued approximately:
\[
Total\, debt = \frac{0.4 \times \text{Total Capital}}{\text{Debt proportion}}
\]
The switch in the cost of debt signifies a critical point at which the firm's cost of debt increases, impacting overall capital costs.
Answer: The firm's debt cost changes at approximately $20 million of debt issued in the higher-cost tranche.
Marginal Cost of Capital Post-Change
After surpassing this threshold, the firm's marginal cost of capital would reflect the higher debt cost: approximately 8.4%, assuming the new debt is the dominant component in financing.
Conclusion
In conclusion, financial decision-making for Medical Research Corporation requires careful balancing of debt and equity to optimize the cost of capital and support its growth ambitions. The initial WACC of about 10.39% provides a baseline for evaluating new projects. As funding surpasses internal retained earnings and moves into external financing, the marginal cost increases, particularly once the company issues debt at higher yields. Recognizing these thresholds helps the firm plan its capital structure efficiently, minimizing costs while maximizing value creation.
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