Question

Landon, the CFO of Marshall Technology Incorporated is planning next year's capital budget. It is at its optimal capital structure, which is 15 percent debt and 85 percent common equity, and the company's earnings and dividends are growing at a constant rate of 12 percent. The last dividend, Do, was $1.00, and the company’s stock currently sells at a price of $22 per share. The firm can raise debt at a 9 percent before-tax cost and is projecting net income to be $2,400,000 with a dividend payout ratio of 25 percent. If the firm issues new common stock, a 7 percent flotation cost will be incurred. The firm's marginal tax rate is 40 percent. If the company ends up spending $3.2 million of new capital, how much new common stock must be sold? a. $920,000 b. $0, the firm still has $56,200 of retained earnings to use. c. $1,082,353 d. $2,550,000 e. None of the above

Answer 1

Marshall Technology Incorporated needs to sell new common stock to meet its capital budget. After calculating retained earnings and considering flotation costs, the firm must issue more than $1.4 million worth of stock, grossed up to account for the flotation costs, which results in approximately $1,505,376.34.

Step-by-step explanation:

The question presents a scenario where Landon, the CFO of Marshall Technology Incorporated, must determine how much new common stock needs to be sold to meet the firm's capital budgeting goals. Given that the company has a dividend growth rate of 12%, a last dividend (Do) of $1.00, and a current stock price of $22, we can use the Gordon Growth Model to calculate the cost of equity.

However, we already know the firm's optimal capital structure (15% debt, 85% equity), the before-tax cost of debt (9%), net income ($2,400,000), dividend payout ratio (25%), and the flotation cost of new stock (7%). Knowing the firm's marginal tax rate is 40% and the need for $3.2 million of new capital, we can determine the amount of new common stock that must be sold.

Firstly, calculate the amount of retained earnings available: $2,400,000 net income x 25% payout ratio = $600,000 in dividends, so $1,800,000 is retained in the firm. Since the firm needs $3.2 million and has $1.8 million in retained earnings, it needs an additional $1.4 million. Considering the 7% flotation costs:
Net amount received = Issue amount x (1 - flotation cost rate). Therefore,
Issue amount = Net amount needed / (1 - flotation cost rate) = $1,400,000 / (1 - 0.07) = $1,505,376.34 is the gross amount to be raised through issuing new stock.