Tucker Inc. makes home kitchen and bathroom faucets. The company was founded 50 years ago by Joseph Tucker and his granddaughter Jill is now chief financial officer. Senior management is contemplating starting a new line of faucets designed specifically for restaurants. Tucker’s marketing department has spent $225,000 on research in this area and is convinced this will be a viable product line for the company. The equipment, facilities, and departments for the new line must be financed and Jill is working on computing the appropriate cost of capital to be used in computing the present value of the line’s future cash flows. Here are the facts facing the firm:
1) Tucker, Inc. has a history of maintaining its target capital structure over the long run.
2) The firm’s outstanding semiannual noncallable bonds carry a 4% coupon rate, mature in 12 years, and are trading in the market today at a price of $975 for each $1,000 face value. The firm has 1,000 bonds outstanding.
3) Tucker’s beta is 1.20 and its last dividend, just paid yesterday, was $4.00. The company expects its earnings to grow at 4% per year into the foreseeable future. The market risk premium is 5%. The risk free rate is 2%. The stock is fairly valued. The firm has 28,125 shares of common stock outstanding. The firm is going to have to issue new shares of common stock to finance the new product line. Common stock flotation costs are 4%.
4) The new product line is slightly riskier than Tucker’s existing business and will require an addition 1.25% required return over the firm’s weighted average cost of capital.
5) The firm’s tax rate 35%.
Assume you are the financial manager working for the CFO. The CFO wants you to recommend an appropriate weighted average cost of capital for Tucker, Inc. and the new product line. As a financial manager, write a letter to Jill, the CFO, discussing your recommendations and the issues surrounding your estimates. Attach your supporting calculations, appropriately labeled so that the CFO can verify your computations. State any relevant assumptions you made. The letter must be typed with 12-point font and should be one page or less. The calculations do not have to be typed, but need to be legible.