Question

 

Eco Plastics Company: The target capital structure for ECO is given by the weights in the following table:

Source of Capital	Weight
Long-term debt	30 %
Preferred stock	20
Common stock equity	50
Total	100 %

At the present time, Eco can raise debt by selling 20 year bonds with a $1,000 par value and a 10.5% annual coupon interest rate. Eco's corporate tax rate is 21%, and its bonds generally require an average discount of $45 per bond and flotation costs of $32 per bond when being sold. Eco's outstanding preferred stock pays a 9% dividend and has a $95-per-share par value. The cost of issuing and selling additional preferred stock is expected to be $7 per share. Because ECO is a young firm that requires lots of cash to grow it does not currently pay a dividend to common stockholders. To track the cost of common stock the CFO uses the capital asset price model (CAPM). The CFO and the firm's investment advisors believe that the appropriate risk-free rate is 4% and that the market's expected return equals 13%. Using data from 2012 through 2018, Eco's CFO estimates the firm's beta to be 1.3.

Although Eco's current target capital structure includes 20 % preferred stock, the company is considering using debt financing to retire the outstanding preferred stock, thus shifting their target capital structure to 50% long term debt and 50% common stock. If Eco shifts its capital mix from preferred stock to debt, its financial advisors expect its beta to increase to 1.5.     

A) Calculate Eco's current after-tax cost of long term debt.

B) Calculate Eco's current cost of preferred stock

C) Calculate Eco's current cost of common stock

D) Calculate Eco's current weighted average cost capital (WACC)

E (1) Assuming that the debt financing costs do not change, what effect would a shift to a more highly leveraged capital structure consisting of 50% long term debt, 0% preferred stock, and 50% common stock have on the risk premium for Eco's common stock? What would be Eco's new cost of common equity?

(2) What would be Eco's new weighted average cost of capital?

(3) Which capital structure-the original one or this one-seems better? Why?

Answer 1

Eco Plastics has a current capital structure of

Source of capital	Weight
Long term debt	30%
Preferred stock	20%
Common stock equity	50%
Total	100%

We have to calculate the cost of debt, preferred stock and common stock one by one.

For the cost of debt

Given , par value of $1000 but it is selling at a discount of $45

Also the flotation cost is $32 per bond , so the net proceeds from selling each bond = $1000-45-32 =$923

The coupon is 10.5% so $105.

To find the cost of debt we have to calculate the YTM

We can use Excel for the same

Given that Eco's corporate tax rate is 21%, the after tax cost of debt is 11.5*(1-0.21) = 9.085%

A) the current after tax cost of long term debt is 9.085%

For the cost of preferred stock

The dividend is 9% of the per share value of $95 , i.e $ 8.55

The net proceeds from a preffered share is $95-$7= $88

The cost of preferred stock then is

Dividend/Net proceeds = 8.55/88 =9.716%

B) the current cost of preferred stock is 9.716%

For the cost of common stock

We use the CAPM

risk free rate =4%

market's expected return, r-m =13%

beta of Eco = 1.3

From CAPM,

cost of equity = risk free rate + beta*(expected market reurn -risk free rate)

=4% + 1.3*(13-4%) = 15.7%

C) the current cost of common stock is 15.7%

D) WACC = w-d*r-d(after tax) + w-p*r-p + w-e*r-e

w-d is the weight of debt

w-p is the weight of preferred stock

and w-e is the weight of common stock

r-d is the after tax cost of debt

r-p is the cost of preffered stock

r-e is the cost of common stock

So WACC = 9.085%*0.3 + 0.2*9.716% + 0.5*15.7% =12.5187%

D) Eco's WACC is 12.5187%

E-1)Post the shift in the capital structure mix, The debt financing costs do not change. The new capital structure is highly leveraged with 50% long term debt and 50% common stock.

The beta of Eco plastics is now 1.5,it has increased

The risk premium of the stock would be unchanged at 13%-4% of 9% but the cost of raising equity will increase due to beta. The cost of equity is 4% + 1.5*(13% -4%) = 17.5%

E-2) Eco's new WACC = r-d(after tax)*w-d + r-e*w-e

There is no preferred stock and debt financing costs do not change

WACC = 0.5*9.085% + 0.5*17.5% = 13.2925%

E-3)The original capital structure seems better due to the lower WACC as compared to the new capital structure. Also more leverage to pay off your preferred stock is not a good option . It reflects that you are raising debt that to long term debt to clear off your preferred stock.