Question

Coleman Technologies Inc. Cost of Capital Coleman 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 must estimate its cost of capital. Assume that you are an assistant to Jerry Lehman, the financial vice president. Your first task is to estimate Coleman’s cost of capital. Lehman has provided you with the following data, which he believes may be relevant to your task:

1. The firm’s tax rate is 40%.

2. The current price of Coleman’s 12% coupon, semiannual payment, noncallable bonds with 15 years remaining to maturity is $1,153.72. Coleman does not use short-term interest-bearing debt on a permanent basis. New bonds would be privately placed with no flotation cost

3. The current price of the firm’s 10%, $100 par value, quarterly dividend, perpetual preferred stock is $111.10.

4. Coleman’s common stock is currently selling for $50 per share. Its last dividend (D0) was $4.19, and dividends are expected to grow at a constant rate of 5% in the foreseeable future. Coleman’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 risk premium of 4%.

5. Coleman’s target capital structure is 30% debt, 10% preferred stock, and 60% common equity.

Questions:

a. What is your final estimate on the cost of common equity?

b. Explain in words why common stock has a higher cost than cost of equity.

c. If Cole estimates its cost of common stock to have a 15% flotation cost, using the DCF approach what will be the cost of new issuances of common stock?

Thank you!

Answer 1

Solution-

A)

TO CALCULATE FINAL ESTIMATE OF COST OF EQUITY (R)-

R= (EQUITY BY CAPM METHOD+ EQUITY BY DCF METHOD+ EQUITY BY BOND YIELD PLUS RISK PREMIUM) / 3

SO,

EQUITY BY CAPM METHOD R_CAPM = RF+ (RM-RF)*B

WHERE,

RF= RISK FREE RATE

RM- RF = MARKET RISK PREMIUM

B = BETA OF STOCK

INSERTING THE VALUES AS GIVEN IN QUESTION-

R_CAPM = RF+ (RM-RF)*B = 7+ (6)* 1.2 = 14.2%

COST OF EQUITY BY DCF METHOD- R_DCF = (D1 / P0) + G AND D1= D0 * (1+G)

WHERE,

D0 = LAST DIVIDEND

D1 = DIVIDEND AFTER 1 YR

P0 = CURRENT PRICE PER SHARE

G= CONTANT GROWTH RATE

INSERTING THE VALUES AS GIVEN IN QUESTION-

D1= D0 * (1+G) = 4.19 * (1+0.05) = 4.3995

R_DCF = (D1 / P0) + G = (4.3995/ 50) + 0.05 = 13.8%

EQUITY BY BOND YIELD MEETHOD - R_BY= BOND YIELD + RISK PREMIUM

INSERTING THE VALUES AS GIVEN IN QUESTION-

R_BY= BOND YIELD + RISK PREMIUM = 10 + 4 = 14%

NOW,

TO CALCULATE FINAL ESTIMATE OF COST OF EQUITY (R)-

R= (RCAPM+RDCF+RBY) / 3 = (14.2 + 13.8 + 14) / 3 = 14%

B)

THE REASON FOR HAVING A HIGHER COST THAN COST OF EQUITY IS THE ADDED COST OF ISSUING THOSE STOCK WHICH ARE ALSO CALLED FLOATING COST.

C)

ADJUSTED COST OF EQUITY BY DCF METHOD- R_DCF = (D1 /(P0*(1-F))+G AND    D1= D0 * (1+G)

WHERE,

D0 = LAST DIVIDEND

D1 = DIVIDEND AFTER 1 YR

P0 = CURRENT PRICE PER SHARE

G= CONTANT GROWTH RATE

F = FLOATING COST

INSERTING THE VALUES AS GIVEN IN QUESTION-

D1= D0 * (1+G) = 4.19 * (1+0.05) = 4.3995

ADJUSTED R_DCF = (D1 /(P0*(1-F))+G = (4.3995/(50*(1-0.15)) + 0.05 = 15.35%