In: Finance
Eco Plastics Company Since its inception, Eco Plastics Company has been revolutionizing plastic and trying to do its part to save the environment. Eco’s founder, Marion Cosby, developed a biodegradable plastic that her company is marketing to manufacturing companies throughout the southeastern United States. After operating as a private company for 6 years, Eco went public in 2012 and is listed on the Nasdaq stock exchange. As the chief financial officer of a young company with lots of investment opportunities, Eco’s CFO closely monitors the firm’s cost of capital. The CFO keeps tabs on each of the individual costs of Eco’s three main financing sources: long-term debt, preferred stock, and common stock. 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 pricing 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. To Do 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? E 2.What would be Eco’s new weighted average cost of capital (WACC)? E 3. Which capital structure—the original one or this one—seems better? Why?
A) Realisation per $1000 par bond = $1000-$45-$32 =$923
So, the Cost of Debt is same as the YTM (r) of the bond priced $923 given by
923 = 105/r*(1-1/(1+r)^20) + 1000/(1+r)^20
Approximate YTM is given by the formula
YTM = (C+(M-P)/n)/(0.4M+0.6P)
where
C = the annual interest payments
M = the maturity (face) value of the bond
P = the current market price of the bond
N = the number of years to maturity
So, r = (105+ (1000-923)/20) / (0.4*1000+0.6*923) =0.1141
Putting r= 0.1141 in the above equation gives value as 929.43
Putting r= 0.1150 in the above equation gives value as 922.90
which is the correct YTM to two decimal places
So, Cost of Debt is 11.50%
Current After tax cost of long term debt is 11.50%* (1-0.21) = 9.085%
B) Dividend on preferred stock =9% of $95 =$8.55
Net received by selling one preferred share = $95-$7 = $88
So, Current cost of preferred stock = $8.55/$88 = .097159 = 9.716%
c) From CAPM, cost of equity is given by
Ke = Riskfree rate + Beta of the firm * (market return -riskfree rate)
=4%+1.3*(13%-4%)
=15.7%
So, the current cost of common stock is 15.7%
D) Weighted Average Cost of capital is given by
WACC= weight of debt * after tax cost of debt + weight of common stock* cost of stock + weight of preferred stock * cost of preferred stock
=0.3* 9.085% + 0.2 * 9.716% + 0.5* 15.7%
= 12.5187% or 12.52%
E1) If there is no change in cost of debt, but beta of the firm increases from 1.3 to 1.5
Risk premium increases by = (1.5-1.3) * (market return- risk free rate)
= 1.8%
New Cost of equity = 15.7%+ 1.8% = 17.5%
This can be verified by applying the CAPM model again
Ke = Riskfree rate + Beta of the firm * (market return -riskfree rate)
=4%+1.5*(13%-4%)
=17.5%
E2) New Weighted Average Cost of capital
WACC= weight of debt * after tax cost of debt + weight of common stock* cost of stock + weight of preferred stock * cost of preferred stock
=0.5* 9.085% + 0.0 * 9.716% + 0.5* 17.5%
= 13.2925% or 13.29%
E3) The original capital structure seems to be better as the overall WACC increases in the new capital structure. This happens because of increased risk and increased cost of Common Stock which is much higher than the small decrease achieved by shifting to 50% debt.