Question

Assume that you were recently hired as assistant to Jerry Lehman, financial vp of Coleman technologies....

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?

Homework Answers

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%

Know the answer?
Your Answer:

Post as a guest

Your Name:

What's your source?

Earn Coins

Coins can be redeemed for fabulous gifts.

Not the answer you're looking for?
Ask your own homework help question
Similar Questions
Coleman Technologies is considering a major expansion program that has been proposed by the company’s information...
Coleman Technologies is considering a major expansion program that has been proposed by the company’s information technology group. Before proceeding with the expansion, the company must estimate its cost of capital. Suppose you are an assistant to Jerry Lehman, the financial vice president. 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 tax rate is 40%. • The current...
Coleman Technologies Inc. Cost of Capital A.​(1)​What sources of capital should be included when you estimate...
Coleman Technologies Inc. Cost of Capital A.​(1)​What sources of capital should be included when you estimate Coleman’s WACC? B.​​What is the market interest rate on Coleman’s debt and its component cost of debt? Enter N, PV, PMT, and FV, and solve for I/YR rd(1 – T) C.​(1)​What is the firm’s cost of preferred stock? rp = ________________________ D.​(1)​Why is there a cost associated with retained earnings? D.​(2)​What is Coleman’s estimated cost of common equity using the CAPM approach? ​rs​= rRF...
Geralt Technologies is considering a major expansion program that has been proposed by the company’s information...
Geralt Technologies is considering a major expansion program that has been proposed by the company’s information technology group. Before proceeding with the expansion, the company need to develop an estimate of its cost of capital. Assume that you are an assistant to Henry Cavill, the financial vice-president. Your first task is to estimate Geralt’s cost of capital. Henry has provided you with the following data, which he believes may be relevant to your task: (i) The firm’s tax rate is...
Given the following data: • The firm’s marginal tax rate is 21%. • The current price...
Given the following data: • The firm’s marginal tax rate is 21%. • The current price of the corporation’s 10% coupon, semiannual payment, noncallable bonds with 15 years remaining to maturity is $1,011.55. The company 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%, $100 par value, quarterly dividend, perpetual preferred stock is $110.12. The company would incur flotation costs of...
DMH Enterprises recently hired you to estimate their cost of capital. The firm’s capital structure consists...
DMH Enterprises recently hired you to estimate their cost of capital. The firm’s capital structure consists 40% debt, 10% preferred stock and 50% common stock. The firm has outstanding bonds with 15 years left to maturity, par value of $1,000 and an annual coupon of 6%. The bonds currently trade for $695.76. The firm's preferred stock is currently selling for $63.64 and pays a dividend of $7. The firm does not plan on issuing new shares of common equity. It...
Rollins Corporation has a target capital structure consisting of 20% debt, 20% preferred stock, and 60%...
Rollins Corporation has a target capital structure consisting of 20% debt, 20% preferred stock, and 60% common equity. Assume the firm has insufficient retained earnings to fund the equity portion of its capital budget. It has 20-year, 12% semiannual coupon bonds that sell at their par value of $1,000. The firm could sell, at par, $100 preferred stock that pays a 12% annual dividend, but flotation costs of 5% would be incurred. Rollins’ beta is 1.2, the risk-free rate is...
Mannheim Biotechnology Limited is expanding the business by considering investing in some profitable projects. Stevenson, a...
Mannheim Biotechnology Limited is expanding the business by considering investing in some profitable projects. Stevenson, a project manager of Mannheim was asked to estimate the cost of capital and evaluate the following projects year 0 1 2 3 4 Project A (100.00) 10.00 50.00 40.00 20.00 Project B (200.00) 80.00 90.00 85.00 10.00 Project C (300.00) 105.00 90.00 110.00 20.00 Albert, the Chief Financial Officer (CFO) of Mannheim has provided him some relevant information. The current bond price of Mannheim’s...
McGee Corporation needs to calculate its marginal cost of capital. You are a financial analyst for...
McGee Corporation needs to calculate its marginal cost of capital. You are a financial analyst for the company and have gathered the following information:                   Dividend, preferred stock……………………….......... …………..$6.00                   Dividend, next expected, Common Stock……….......... ………..$1.10                   Price, Preferred Stock (ignore any flotation cost)….......... ……$48.00                   Price, Common Stock………………………………….......... …..$25.00                   Flotation cost per share, common........................ 20% of stock price                   Growth rate…………………………………………….......... ………10%                   Bond yield........... …………………………………………………….11%                   Bond face .......... ………………………………………………$1,000.00                   Net income…………………………………………….... …….$25 million                   Dividend...
You were hired as a consultant to AICC Company, whose target capital structure calls for 30%...
You were hired as a consultant to AICC Company, whose target capital structure calls for 30% debt, 5% preferred, and 65% common equity. The Company’s common stock currently sells at $20 per share and just paid $1 annual dividend per share (D1). The dividend is expected to grow at a constant rate of 5% a year. (10 pts) Using the DCF model, what is the company’s cost of common equity. If the firm’s beta is 1.2, the risk-free rate ,rfr...
During the last few years, Harry Davis Industries has been too constrained by the high cost...
During the last few years, Harry Davis Industries has been too constrained by the high cost of capital to make many capital investments. Recently, though, capital costs have been declining, and the company has decided to look seriously at a major expansion program that had been proposed by the marketing department. Assume that you are an assistant to Leigh Jones, the financial vice-president. Your first task is to estimate Harry Davis’ cost of capital. Jones has provided you with the...