Question

Assume that you were recently hired as assistant to Jerry Lehman, financial vp of Coleman technologies. Your first task is to estimate Coleman’s cost of capital. Lehman has provided you with the following data, which he believes may be relevant to your task:

The firm’s marginal tax rate is 40 percent.
The current price of Coleman’s 12 percent coupon, semiannual payment, noncallable bonds with 15 years remaining to maturity is $1,153.72. Coleman does not use short-term interest-bearing debt on a permanent basis. New bonds would be privately placed with no flotation cost.
The current price of the firm’s 10 percent, $100 par value, quarterly dividend, perpetual preferred stock is $113.10. Coleman would incur flotation costs of $2.00 per share on a new issue.
Coleman’s common stock is currently selling at $50 per share. Its last dividend (d0) was $4.19, and dividends are expected to grow at a constant rate of 5 percent in the foreseeable future. Coleman’s beta is 1.2, the yield on treasury bonds is 7 percent, and the market risk premium is estimated to be 6 percent. For the bond-yield-plus-risk- premium approach, the firm uses a 4 percentage point risk premium.
Up to $300,000 of new common stock can be sold at a flotation cost of 15 percent. Above $300,000, the flotation cost would rise to 25 percent.
Coleman’s target capital structure is 30 percent long- term debt, 10 percent preferred stock, and 60 percent common equity.
The firm is forecasting retained earnings of $300,000 for the coming year.

1) What is the estimated cost of retained earnings using the discounted cash flow (DCF) approach?
2) What is the bond-yield-plus-risk-premium estimate for Coleman’s cost of retained earnings?

3) What is your final estimate for rs?

4) What is Coleman's cost for up to $300,000 of newly issued common stock, re1? What happens to the cost of equity if Coleman sells more than $300,000 of new common stock?

Answer 1