Question

Dandy Panda´s Japan affiliated company presents a capital structure which is also its target capital structure, which calls for 50% debt and 50’% common equity. Tokyo´s manufacturing has only one (1) potential project, an expansion program with a 10.2% IRR and a cost of USD 20 million.

However, the project is completely divisible, that is Panda´s directors can decide to invest any amount up to USD 20 million.
Tokyo expects to retain $3 million of earnings next year. It can raise debt at a pre-tax annual cost of 10%. The cost of the retained earnings in the Balance sheet would be 12% per year. Dandy Panda Japan can sell new stock at a constant cost of new equity of 15%.
Japan has a marginal tax rate of 40%
What is Dandy Panda´s Japan optimal Capital Budget to be calculated by the Company between zero and USD 20 million?

Answer 1

The optimal capital budget for Dandy Panda Japan's project is $272.86 million.

Step-by-step explanation:

To calculate Dandy Panda Japan's optimal capital budget for the project, we need to determine the cost of debt and the cost of equity. Firstly, the cost of debt is 10% and the retained earnings on the balance sheet have a cost of 12%. Next, the cost of equity is 15%. Considering a marginal tax rate of 40%, we can calculate the weighted average cost of capital (WACC) using the target capital structure of 50% debt and 50% common equity. The WACC is calculated as follows:

1. Weight of debt = 0.5 * 0.1 = 0.05
2. Weight of equity = 0.5 * (1 - 0.4) = 0.3
3. WACC = (0.05 * 0.1) + (0.3 * 0.15) = 0.07

The WACC of 0.07 represents the cost of capital for Dandy Panda Japan. Now, we can determine the optimal capital budget for the project. Using the formula:

Optimal Capital Budget = (Retained Earnings + Debt / WACC) - Retained Earnings

Let's calculate the optimal capital budget:

(3 million + 20 million / 0.07) - 3 million = $272.86 million

Therefore, Dandy Panda Japan's optimal capital budget for the project is $272.86 million.