Bonds with a face value of $12 million. The bonds would have a 9 percent coupon rate and would net $12 million after flo
Richmond - WACC
Richmond Inc. operates a chain of department stores located in the northwest. The first store began operations in 1965, and the company has steadily grown to its present size of 44 stores. Two years ago, the Board of Directors of Richmond approved a large-scale remodeling of its stores to attract a more upscale clientele. Before finalizing these plans, two stores were remodeled as a test. Linda Perlman, assistant controller, was asked to oversee the financial reporting for these test stores, and she and other management personnel were offered bonuses based on the sales growth and profitability of these stores. While completing the financial reports, Perlman discovered a sizeable inventory of outdated goods that should have been discounted for sale or returned to the manufacturer. She discussed the situation with her management colleagues; the consensus was to ignore reporting this inventory as obsolete because reporting it would diminish the financial results and their bonuses. The report presented to the Board showed sales growth of 11 percent and a 14 percent increase in profitability. Based on the apparent success of this test, the Board is now considering the following two alternatives for financing the balance of the remodeling effort. Pure debt alternative: This alternative would consist of a public offering of a public offering of bonds with a face value of $30 million. The bonds would have an 11 percent coupon rate and would net $30 million after flotation costs. Combination alternative: This alternative would be financed with: •
Bonds with a face value of $12 million. The bonds would have a 9 percent coupon rate and would net $12 million after flotation costs.
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Preferred stock with a stated rate of 7 percent. The preferred stock would yield $4.5 million after a 5 percent flotation cost.
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Common stock that would yield $9 million after a 5 percent flotation cost.
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Retained earnings in the amount of $4.5 million.
The current market value of Richmond’s common stock is $30 per share. The dividend on the common stock during the past 12 months was $3.00 per share, and investors are expecting the growth rate of dividends to be 6 percent. Richmond’s present capital structure consists of $40 million long-term debt, $15 million preferred stock, and $45 million common equity. The company has been advised that its capital structure is considered optimal for retailing. The chain is subject to an effective income tax rate of 40 percent. Required: 1. Determine Richmond Inc.’s after-tax weighted marginal cost of capital for the pure debt alternative. 2. Determine Richmond Inc.’s after-tax weighted marginal cost of capital for the combination alternative. 3. Explain why the interest rate on the bonds is greater for the pure debt alternative than it is for the combination alternative. 4. Evaluate the actions of Linda Perlman by citing the specific standards (competence, confidentiality, integrity, credibility) in the IMA Statement Of Ethical Professional Practice.
