Question

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 needs to develop an estimate of 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 firms tax rate is 25% 2) The current price of Coleman’s 12% coupon, semiannual payment bond 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 will be privately placed with no flotation cost. 3) The current price of the firm’s 10%, $100.00 par value, quarterly dividend, perpetual preferred stock is $111.10 4) Coleman’s common stock is currently selling for $50.00 per share. Its last dividend was $4.19, and dividends are expected to grow at a constant annual rate of 5% in the foreseeable future. Coleman's common stock is selling for $50.00 per share,. It's last dividend (D0) was $4.19, and dividends are expected to grow at a constant rate of 5 percent in the foreseeable future. Coleman’s beta is 1.2, the yield on T-bonds is 7 percent, and the market risk premium is estimated to be 6 percent. For the bond-yield-plus-risk-premium approach, the firm uses a risk premium of 4 %. Coleman’s target capital structure is 30% debt, 10% preferred stock, and 60% common equity. To structure the task somewhat, Lehman has asked you to answer the following questions:

1) A What sources of capital should be included when you estimate Coleman's WACC? (2) . Should the component be figured on a before-tax or an after tax basis? (3) Should the costs be historical (embedded) costs or new marginal) costs? B. What is the market interest rate on Coleman's debt and its component cost of debt? C. (1) What is the firm's cost of preferred stock? (2) Coleman's preferred stock is riskier to investors than its debt, yet the preferred's yield to investors is lower than the yield to maturity on the debt. Does this suggest that you have made a mistake? (Hint: Think about taxes.) D. (1) Why is there a cost associated with retained earnings? (2) What is Coleman’s estimated cost of common equity using the DCF approach? E) What is the estimated cost of common equity using the CAPM approach? F) What is the bond-yield-plus-risk premium estimate for Coleman's cost of equity? G)What is your final estimate for Rs? H) Explain in words why new common stock has a higher cost than retained earnings. I) What are two approaches that can be used to approaches that can be used to adjust for flotation costs? J. What is Coleman’s overall, or weighted average, cost of capital (WACC)? Ignore flotation costs. K. What factors influence Coleman’s composite WACC? L. Should the company use the composite WACC as the hurdle rate for each of its projects? Explain.

Answer 1

A.1. The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets. The WACC is commonly referred to as the firm's cost of capital. Basically, WACC is used for making long-term capital investment decisions like for capital Budgeting. The sources of capital that should be included while estimating Coleman's WACC should include the types of capital used to pay for long-term assets i.e.,:

i) Debt (All interest-bearing debt), whether short- term or long-term

ii) Preferred Stock

iii) Common equity

A.2. Since, cash flows to be given out to creditors and investors i.e., dividends and reinvestment is made with after-tax dollars, all cash flow and rate of return calculations should be done on an after-tax basis.

A.3. Since, WACC is based on future 'target' capital structure and the cost of capital is used primarily to make decisions that involve raising new capital. So, the relevant component costs are today’s marginal costs rather than historical costs.

B.1.

The Market interest rate on Coleman's debt is the bond's yield to maturity(YTM). For calculating YTM we need following values:

a) Future value is equal to the par value of the bond, (FV) = - $1000

b) Present value is equal to the price of bond, (PV) = 1153.72

c) Coupon Payment, (C) = $1000 x (12% / 2) = $60

d) Number of Payments, (n) = 15 x 2 = 30

YTM = {C + [ (FV - PV) / t] } / [ (FV+ PV) / 2]

= { 60 + [ (-1000 +1153.72) / 15] } / [ (-1000 + 1153.72) / 2]

= 10% (Approx)

Since, YTM (rd) the pre-tax cost of debt = 10% and interest is tax deductible. Thus, Coleman’s relevant component cost of debt is the after-tax cost:

rd(1 – T) = 10.0% (1 – 0.40) = 10.0%(0.60) = 6.0%.

C.1. Firm's cost of preferred stock (rp) = Dp / Pp

where rp = cost of preffered stock  

Dp = annual dividend per share

Pp = Price of preffered stock

rp = Dp / Pp   

= (10% x 100) / $111.10

= $10 / $111.10

= 9%

C.2. Corporate investors own most preferred stock, because 70% of preferred dividends received by corporations are nontaxable. Therefore, preferred often has a lower before-tax yield than the before-tax yield on debt issued by the same company. And since the YTM on bonds is before tax, both rates should be after tax when compared and the after-tax cost of debt is 6%. Thus we have not made any mistake.

D.1. The Cost associated to retained earnings explains If earnings are retained, Coleman’s shareholders forgo the opportunity to receive cash and to reinvest it in stocks, bonds, real estate, and the like. Thus, Coleman should earn on its retained earnings at least as much as its stockholders themselves could earn on alternative investments of equivalent risk.

Further, the company’s stockholders could invest in Coleman’s own common stock, where they could expect to earn rs. From this we conclude that retained earnings have an opportunity cost that is equal to rs, the rate of return investors expect on the firm’s common stock.

D.2. For calculating CAPM we require following values:

rs (Required return on stock)

rRF(Risk-free rate) = 7%

rM - rRF (Market risk premium) = 6%

b (Beta of stocck) = 1.2

                  rs = rRF + (rM – rRF)b

                       = 7.0% + (6.0%)1.2 = 7.0% + 7.2% = 14.2%

The CAPM estimate for Coleman’s cost of common equity is 14.2%

E. Since Coleman is a constant growth stock, the constant growth model i.e.,DCF approach can be used:

We can go for Gordon Growth model

rs = (D1 / P0) + g

= [D0 (1+g) / P0]+ g

= [$4.19(1+ 5%) / $50.00] + 5%

= [$4.19(1+ 0.05) / $50.00] + 5%

= [$4.19 (1.05) / $50.00] + 5%

= [$4.40 / $50.00] + 5%

= 8.8% + 5%

= 13.8%

F. The bond-yield-plus-risk-premium estimate(rs ) is 14%:

rs = Bond yield + Risk premium = 10.0% + 4.0% = 14.0%.