FIN 534 Homework Set 4

Homework Set #4: Chapters 9, 10, & 11
Due Week 8 and worth 100 points

Directions: Answer the following questions on a separate document. Explain how you reached the answer or show your work if a mathematical calculation is needed, or both. Submit your assignment using the assignment link above.

A. Bad Boys, Inc. is evaluating its cost of capital. Under consultation, Bad Boys, Inc. expects to issue new debt at par with a coupon rate of 8% and to issue new preferred stock with a $2.50 per share dividend at $25 a share. The common stock of Bad Boys, Inc. is currently selling for $20.00 a share. Bad Boys, Inc. expects to pay a dividend of $1.50 per share next year. An equity analyst foresees a growth in dividends at a rate of 5% per year. Bad Boys, Inc. marginal tax rate is 35%. If Bad Boys, Inc. raises capital using 45% debt, 5% preferred stock, and 50% common stock, what is Bad Boys cost of capital?

WACC = wdrd(1-T) + wstdrstd(1-T) + wpsrps + wsrs

rd = 8%rps = 15.50%rs = 12.5%

T = 35%

wd = 45%wps = 5%ws = 50%

WACC = .45*.08(1-.35) + .05*.155 + .50*.125

= .036(.65) + .00775 + .0625

= .0234 + .00775 + .0625

= .09365 = 9.4%

*rps = 2.5(1+5%)/25+5% = 15.5

*rs = 1.5/20 + 5% = 12.5

B. If Bad Boys, Inc. raises capital using 30% debt, 5% preferred stock, and 65% common stock, what is Bad Boys cost of capital?

rd = 8%rps = 15.50%rs = 12.5%

T = 35%

wd = 30%wps = 5%ws = 65%

WACC = .30*.08(1-.35) + .05*.155 + .65*.125

= .024(.65) + .00775 + .08125

= .0156 + .00775 + .08125

= .1046 = 10.5%

C. On page 457, your textbook details the term Cannibalization. In your own words, identify two corporations that have dealt with cannibalization and what steps were taken to overcome the cannibalization. Please provide any citations and references. Please be articulate in your responses.

Cannibalization is when new business eats into the company’s existing business. One example would be opening a new location close to a current one, leading to the new store eating into the previous store’s profits. Another example would be coming out with a new product that takes profits away from a previous product. One corporation that has dealt with cannibalization is Starbucks, in the form of new stores opening relatively close to existing stores. One step that has been made to overcome this cannibalization is to slow down store expansion. Management is beginning to take a closer look at store additions and reevaluate the effect new additions will have on existing ones and if it is profitable to open more stores in the same geographic location. In some instances, this form of cannibalization could be good for Starbucks as it could potentially alleviate the strain on high traffic locations, potentially drawing new customers in and older customers back and at a more frequent occurrence.

Apple is another company that has dealt with cannibalization, and still does so today. The iPod Nano replaced the iPod Mini, the iPhone essentially replaced the iPod, and the iPad cannibalized the Mac laptops and desktops. While Apple continues to deal with cannibalization, they seem to always come out on top and that is due to the fact that if they did not come out with these new products, then a competitor eventually would have. As Steve Jobs once reportedly stated, “If you don’t cannibalize yourself, someone else will.” If Apple did not come out with the iPod, the iPhone and the iPad, then someone else would have and Apple would have missed out on a tremendous opportunity.

References

Brigham & Ehrhardt. (2017). Financial Management: Theory and Practice (15th ed.)

Boston, MA: Cengage Learning.

CFI Education. (2018). Cost of Preferred Stock. Retrieved from

https://corporatefinanceinstitute.com/resources/knowledge/finance/cost-of-preferred-stock/.

Muller, T. (2008). Starbucks Traffic Decline Is Due to Cannibalization. Retrieved from

https://seekingalpha.com/article/62893-starbucks-traffic-decline-is-due-to-cannibalization.

Smirnov, Y. (2018). Cost of Common Stock. Retrieved from

http://financialmanagementpro.com/cost-of-common-stock/.

Yu, H & Malnight, T. (2016). The Best Companies Aren’t Afraid to Replace Their Most

Profitable Products. Retrieved from https://hbr.org/2016/07/the-best-companies-arent-afraid-to-replace-their-most-profitable-products.