Question

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.

1. The current bond price of Mannheim’s 10% coupon, semiannual payment with 10 years left to maturity is $1,134.20. The par value of the bond is $1,000. The company’s tax rate is 40%.
2. The current price of the preferred stock is $31.25 with annual dividend payment of $3.75.
3. Mannheim’s common stock is currently selling for $45 per share. Its last dividend payment was $3.25 and dividend is expected to grow at a constant rate of 3% in the foreseeable future. Mannheim’s beta is 1.2, the risk free rate is 6%, and the market risk premium is estimated to be 4%. For the bond-yield-plus-risk-premium approach, the firm uses a risk premium of 4% with the yield on the Treasury bond of 6.5%
4. Sharron, a finance manager of Mannheim, has $400 million capital available consisting of $160 million debt, $140 preferred stock, and $100 million common stock.

Albert asked Stevenson to prepare a report answering the following questions:

1. What are the sources of capital to be included when estimating the Mannheim’s WACC? In calculating the WACC, if he had to use book values for either debt or equity, which would he choose? Why?                                                                     
2. What is the cost of debt after tax?                                                          
3. What is the firm’s cost of preferred stock?                                              
4. Explain why there is a cost of retained earnings?                                  
5. What is Mannheim’s estimated cost of common equity using the CAPM approach?                                                                                                                              
6. What is the estimated cost of common equity using the DCF approach?
7. What is the bond-yield-plus-risk-premium estimate for Mannheim’s cost of common equity?                                                                                                  
8. What is your final estimate for r_s or the average required rate of return?
9. Explain in words why new common stock has a higher cost than retained earnings.                                                                                                                    
10. Mannheim estimates that if it issues new common stock, the flotation cost will be 20%. Mannheim incorporates the flotation costs into the DCF approach. What is the estimated cost of newly issued common stock, considering the flotation cost?
11. What is Mannheim’s overall, or weighted average, cost of capital (WACC)? Ignore flotation costs.                                                                                          
12. What are the factors affecting Mannheim’s composite WACC?            
13. Calculate the Net Present Value (NPV), Discounted Payback Period (DPP) and Modified Internal Rate of Return (MIRR) for Project A, B, and C.                            
14. Mannheim Biotechnology Limited has $400 million capital available. Since the projects above are independent, which project should the company invest?    
15. If Mannheim had 14% cost of equity, 6% preferred shares and 8% debt, Stevenson proposed a target capital structure of 60% equity, 5% preferred shares, and 35% debt. Explain why he doesn’t use more preferred shares since it costs less than debt.

Answer 1

a.

In calculating WACC we would consider Bonds, Preferred Stock and Common Equity. If Book values had to be considered we would use Book value of Debt as it is closer to the Market price of Debt, while there is large variations in Book Value and Market Value of Equity Stocks.

b

Using yield plus risk approach - 6.5%+4%.

After tax cost of debt = 10.5*(1-40%) = 6.3%

c.

Cost of preferred Stock = 3.75/31.25

=12 %

d.

The cost of those retained earnings equals the return shareholders should expect on their investment. It is called an opportunity cost because the shareholders sacrifice an opportunity to invest that money for a return elsewhere and instead allow the firm to build capital.