Question

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 40%.

(ii) The current market price of Geralt’s $1,000 par value, 12 percent coupon, semi-annual payment, non-callable bonds with 15 years remaining to maturity is $1,153.72. Geralt does not use short-term interest-bearing debt on a permanent basis.

(iii) The current price of the firm’s 10%, $100 par value, annual dividend, perpetual preferred stock is $111.10. The company would incur a issuing cost of 6%.

(iv) Geralt’s common stock is currently selling at $50 per share. Its last dividend was $4.19, and dividends are expected to grow at a constant rate of 5% in the foreseeable future. Geralt’s beta is 1.2, the yield on T-bonds is 7%, and the market risk premium is estimated to be 6%. For the bond-yield-plus-risk-premium approach, the firm uses a 4% point risk premium.

(v) Geralt’s target capital structure is 30% long-term debt, 10% preferred stock, and 60% common equity.

To structure the task somewhat, Henry has asked you to answer the following questions ( Without using financial Calculator ):

1. a) What is your final estimate for ???

(b) Explain in words why new common stock has a higher percentage cost than retained earnings.

(c) Geralt estimates that if it issues new common stock, the flotation costs will be 15%. Geralt incorporates the flotation costs into the DCF approach. What is the estimated cost of newly issued common stock, taking into account the flotation cost?

Answer 1

1. a)

Using CAPM: Ks = Rf + beta x Rmp = 7% + 1.2 x 6% = 14.2%

Using DCF: Ks = D1 / P0 + g = 4.19 x (1 + 5%) / 50 + 5% = 13.80%

Hence, the final estimate of Ks = average of the two values = (14.2% + 13.8%) / 2 = 14.00%

Part (b)

New common stock always has flotation cost. Issuance of new common stock has its own cost. Such cost reduces the net price of issue and hence increases the cost of capital. Hence, new common stock has a higher percentage cost than retained earnings.

Part (c)

Net price = P0 x (1 - F) = 50 x (1 - 15%) = 42.50

Using DCF: Ks = D1 / Net Price + g = 4.19 x (1 + 5%) / 42.50 + 5% = 15.35%