Micron’s board of directors wants to raise $2,000,000 of capital this year. Retained earnings are only $100,000. Interest is 12%, their tax rate is 40%, and they have decided not to issue any preferred stock. Their optimum capital structure for new capital is 80% debt, of which 5% will be raised by

Question

Micron’s board of directors wants to raise $2,000,000 of capital this year. Retained earnings are only $100,000. Interest is 12%, their tax rate is 40%, and they have decided not to issue any preferred stock. Their optimum capital structure for new capital is 80% debt, of which 5% will be raised by increasing accounts payable and 75% will be a bank loan, and 20% common equity. The cost of common equity (which includes retained earnings) is 14.5%, and the cost of new common stock is 16%. What will be their WACC?

Accepted Answer

To solve this problem, we must determine how much of the $2 million capital goal retained earnings will support; then, of the remainder, we must solve for how much new common equity must be issued.
a. Compute the amount of new capital that new retained earnings will support.

[latex]\begin{aligned} ext { New capital } & = ext { Retained earnings } / ext { Target percent of equity } \& =\$ 100,000 / 20 \%=\$ 500,000\end{aligned}[/latex]

b. Compute the remaining amount of capital to be raised.

[latex]\begin{array}{lll} ext{Remaining capital}\ ext{to be raised}\end{array}= ext{ \$2,000,000 - \$500,000 = \$1,500,000}[/latex]

c. Compute the amount of new equity from common stock
that must be raised.

[latex] ext { New equity from common stock }=\$ 1,500,000 imes 20 \%=\$ 300,000[/latex]

d. Compute the weight of the new retained earnings.

[latex]Ws =\$ 100,000 / \$ 2,000,000=5 \%[/latex]

e. Compute the weight of the newly issued common stock.

[latex]We =\$ 300,000 / \$ 2,000,000=15 \%[/latex]

Applying Eq. 9–11 to Micron’s capital structure,

[latex]\begin{aligned} ext { Capital capacity } & = ext { Retained earnings } / ext { Target percent of equity } \% \& =\$ 100,000 / 40 \%=\$ 250,000\end{aligned}[/latex] (Eq. 9–11)

as shown in Figure 9–2, we can see that shifting their debt/equity ratio on the margin has reduced their weighted average cost of capital.
Even with the modest changes in incremental capital, Micron’s weighted average cost of capital is decreasing. Were they to make a significantly greater use of debt, which is costing them net 7%, they could probably drive their cost of capital below 8%. Balanced against that is the reality that the more debt they use, the more volatile their net income will be, the greater their risk relative to the market, and the greater their risk as perceived by bond rating services, which will increase the yield demanded by the market.

Reasonableness check: Is the weighted average cost of capital between the cost of the most expensive component and the least expensive component? If not, there is a math or formula error somewhere. Did the weighted average cost of capital go up when new equity, burdened by flotation costs was used? If not, check formulas and math.
If the cost of preferred stock capital is cheaper than the cost of new common equity capital, why not use all preferred stock to raise the target $2 million? An excellent question, the answer to which turns in part on the market demand for preferred stock. Most investors want to participate in capital gains, an opportunity not afforded to preferred shareholders unless there is a conversion option. Or, investors want an interest-bearing bond that they perceive as safer because interest is paid before preferred dividends. In designing a capital structure, all is balance.

Question 9.11: Micron’s board of directors wants to raise $2,000,000 of cap...

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