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.

To structure the task somewhat, Lehman has asked you to answer the following questions:

a.1) What sources of capital should be included when you estimate Coleman’s weighted average cost of capital (wacc)?

a.2.) Should the component costs be figured on a before-tax or an after-tax basis? explain.

a.3.) Should the costs be historical (embedded) costs or new (marginal) costs? explain.

b.) What is the market interest rate on Coleman’s debt and it component cost of debt?

optional question: Should flotation costs be included in the estimate?
optional question: Should you use the simple cost of debt or the effective annual cost?

c.1) What is the firm’s cost of preferred stock?

c.2) Coleman’s preferred stock is riskier to investors than its debt, yet the yield to investors is lower than the yield to maturity on the debt. Does this suggest that you have made a mistake? (hint: think about taxes.)

d.1) Why is there a cost associated with retained earnings?
d.2) What is Coleman’s estimated cost of retained earnings using the CAPM approach?

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

g.) What is your final estimate for rs?

h.) 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

As per rules I am answering the first 4 subparts of the question

1: The WACC should include both debt and equity.Hence we need to compute the cost of bonds, preference stock and common stock in the computation.

2: The costs should be computed after tax. This is applicable to cost of debt since the tax saving on interest reduces the cost of debt financing. In case of preference and common stock, there is no tax deduction on equity and hence the tax impact becomes irrelevant.

3: The costs should be the marginal costs as we need to consider the cost of funds as they would be if new finance is raised from the market.

4:

Using financial calculator

Input: FV= 1000, PMT=12%*1000/2 = 60

PV = -1153.72

N= 15*2 = 30

Find I/Y as 5

Hence the semiannual YTM is 5%

Annual YTM = 10%

Cost of debt = YTM*(1-Tax)

= 10%*(1-0.4)

= 6%