Question

During the last few years, Mike Rogers Industries has been too constrained by the high cost of capital to make may capital investments. Recently, though , capital cost 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 Mike Rogers' cost of capital. Jones has provided data that she believes is relevant to your task.

(1) The firm's tax rate is 25%

(2) The current price of Mike Rogers' 6 percentage coupon, semiannual payment, noncallable bonds with 15 years remaining to maturity is $1,102.33. Mike Rogers does not use short-term interest-bearing debt on a permanent basis. New bonds would be privately placed with no flotation costs.

(3) The current price of the firm's 5.5 percentage, $100 par value, quarterly ,dividend, perpetual preferred stock is $108.35. Mike Rogers would incur flotation costs equal to 5 percent of the proceeds on a new issue.

(4) Mike Rogers'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 rale of 5 % in the foreseeable future. Mike Roger's beta is 1.2, the yield on T-bonds is 3 percent, and the market risk premium is estimated to be 7 percent.

(5) Mike Rogers' target capital structure is 30 percent long-term debt, 10 percent preferred stock, and 60 percent common equity.

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

a. (1) What sources of capital should be included when you estimate Mike Rogers' weighted average cost of capital (WACC)

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

   (3) Should the costs be historical (embedded) costs or new (marginal) cost?

b. What is the market interest rate on Mike Rogers' debt and its component cost of debt?

COST OF PREFERRED STOCK, rp

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

COST OF EQUITY (INTERNAL) , rs

d. (1) What are the two primary ways companies raise common equity?

   (2) Mike Rogers does not plan to issue new shares of common stock. Using the CAPM approach, what is Mike Rogers' estimated cost of equity?

THE WEIGHTED AVERAGE COST OF CAPITAL

The weighted average cost of capital (WACC) is calculated using the firm's target capital structure together with its after-tax cost of debt, cost of preferred stock, and cost of common equity.

PROBLEM

e. What is Mike Rogers' weighted average cost of capital (WACC)?

Answer 1

Easy one, We will solve:

Question:

What sources of capital should be included when you estimate Mike Rogers' weighted average cost of capital (WACC)

Answer: Each CFO will try to make a plan for the the future. So, the instrumetns which they are using should be of long-term. Hence, CFO will go for the Long term sources of funds i.e, Common Equity, Pref. Equity & Debt. For the given question we will go for long term capital generation source. If they are going to meet the working capital, they will go for the SHort term insturments which are Non-interest & Interest bearing instrumetns.

Question:

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

Answer: See, we have to go with after tax basis because the stockholders will be paid dividends after the TAX has been deducted. Also, if the company is not interested in not paying dividedns; it has to retain some earnings which will be generated after the tax has been paid. Look the income statemnets, we will have the retained earnings after the tax is cut. Hence, conisder the after tax basis.

Question:

Should the costs be historical (embedded) costs or new (marginal) cost?

Answer: Remember one thing , When you go for New issue of capital -> Go for Marginal else go for Embedded. Because you are rasiing the capital for the future and the "Increase in Inflation" will come. So, How can you think of PAST? think for a while. You will get your reasoning to the idea of going to marginal costs.

Question:

What is the market interest rate on Mike Rogers' debt and its component cost of debt?

Haa,, we have to find here the COst of Debt (or) Yield to Maturity (YTM)

he current price of Mike Rogers' 6 percentage coupon, semiannual payment, noncallable bonds with 15 years remaining to maturity is $1,102.33. Mike Rogers does not use short-term interest-bearing debt on a permanent basis. New bonds would be privately placed with no flotation costs.

Bonds are semi - annual means coupon is paid twice in year. So frequency is 2

YTM= [ C+(F-P)/N ] / ( 0.4*F +0.6*P )

Coupon Amount (C)= (Coupon rate/2) * Face value = (6%/2)*1000= 30

No of years (N)= 15*2 = 30 periods ( Multiplied by 2 because of semi - annual )

F is face value; P is elling price

YTM= [ 30 + (1000-1102.33)/30 ] / (0.4* 1000 + 0.6*1102.33)

YTM = 2.51%

It is the semi annual , so convert to Annual by multiolying with 2

YTM= 2.51*2

YTM= 5.02%

After tax cost of debt = YTM * (1- Tax rate)

=5.02% * (1-25%)

After tax COD= 3.77%

Cost of preferred Stock = Dividend/ [ Price *(1-Flotation cost) ]

Dividend is paid at face value= 5.5% * 100 = 5.5

COP= 5.5 / [ 108.35*(1-5%) ]

Cost of preferred Stock = 5.34%

Question

d. (1) What are the two primary ways companies raise common equity?

Answer: Retained earnings & Issue of common equity means going for IPO

Question

d. (2) Mike Rogers does not plan to issue new shares of common stock. Using the CAPM approach,

what is Mike Rogers' estimated cost of equity?

Answer: Cost of Common equity = Risk free rate + Beta* ( Market return - Risk free rate)

= 3 + 1.2*(7-3)

Cost of Common equity (COE) = 7.8%

Question

e. What is Mike Rogers' weighted average cost of capital (WACC)?

WACC= (weight of equity * COE ) + (weight of Debt *after tax COD) + (Weight of pref stock * COP)

(60% * 7.8%) + (30% * 3.77%) + (10% * 5.34%)

WACC= 6.34%