Earnings Multiple and Cost of Capital. The Jefferson Corporation is contemplating a $50 million expansion project. Over the years, the firm’s board of directors has adhered to a policy of rejecting any investment proposal that would jeopardize the market value of the firm’s common stock.
A preliminary analysis projected a rate of return on the new project of around 14 percent before taxes. Jefferson has reached tentative agreement with an insurance company to finance the project through a private placement of the $50 million in the form of 10 percent notes.
The firm’s common stock has been historically selling at 10 times after-tax earnings. Current earnings per share are $2.70 and the firm faces a 50 percent corporate income tax rate.
Long-term debt (8%) $10,000,000
Common stock ($2 par, 10,000,000
shares outstanding)
Paid-in capital, in excess of par 70,000,000
Retained earnings 100,000,000
Total capitalization $200,000,000
(a) One of the members of Jefferson Corporation’s board of directors argued that the firm should immediately place the notes, since the before-tax marginal cost of capital for the project is only 10 percent (the interest on the notes), and indications are that the project’s before-tax rate of return would be greater than 10 percent. Discuss.
(b) Assuming Jefferson’s earnings multiple declines to 9, what level of annual earnings must the new project generate in order to meet the director’s objective? (CMA, adapted).