COST OF CAPITAL
The Problem
On January 1, 1997 Bunky's Burgers, Inc. is planning its yearly capital budget and is faced with a list of 5 potential independent proposals: PROJECT | OUTLAY | IRR | A | 8,000,000 | 14.0% | B | 8,000,000 | 21.0% | C | 10,000,000 | 19.0% | D | 12,000,000 | 13.5% | E | 12,000,000 | 16.0% |

The firm's capital structure relations shown below are considered optimal and will be maintained: Debt | $120,000,000 | Preferred Stock | 20,000,000 | Common Equity | 60,000,000 | TOTAL CLAIMS | $200,000,000 |
The firm has a marginal tax rate of 35% and has $4,500,000 from internal sources of equity available for investment. Four years ago Bunky's paid a common stock dividend of $5.545 a share. Yesterday they paid a dividend of $7.00. Assume that this dividend growth rate continues for the indefinite future. The common stock is currently priced to produce a dividend yield (based on the next dividend) of 18%.
Bunky's can raise new funds under the following conditions:
BONDS: (Up to $24,000,000) New 20 year $1000 par value bonds carrying a coupon of 12 per cent (payable annually) are priced to yield the investor 10% a year. Flotation costs total $70.27 per bond.
(Beyond $24,000,000) A second issue of 20 year 12 per cent coupon bonds can be sold to yield the investor 14% a year. Flotation costs total $67.54.
PREFERRED STOCK: Any size issue of new preferred stock can be sold to yield the investor 16%. Underwriters charge a fee of 20% of the selling price.
COMMON STOCK: Issuing up to $7,500,000 of new common stock requires underpricing and flotation costs equal to 20% of the stock's price. Beyond $7,500,000 requires flotation costs equal to 30% of the selling price.
{a} Which projects should Bunky's accept? Your analysis must include the calculation of the marginal cost of capital along all of the various segments.