Question

Assume that you were recently hired as assistant to Jerry Lehman, financial VP of Coleman Technologies. Your first task is to estimate Coleman’s cost of capital. Lehman has provided you with the following data, which he believes is relevant to your task:

The firm’s marginal tax rate is 40%.

The current price of Coleman’s 12 % coupon, semiannual payment, noncallable bonds with 15 years remaining to maturity is $1,153.72. New bonds would be privately placed with no flotation cost.

The current price of the firm’s 10%, $100 par value, quarterly dividend, perpetual preferred stock is $113.10. Coleman would incur flotation costs of $2 per share on a new issue.

Coleman’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 rate of 5% in the foreseeable future. Coleman’s beta is 1.2, the yield on Treasury 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 four-percentage point risk premium.

Up to $300,000 of new common stock can be sold at a flotation cost of 15%. Above $300,000, the flotation cost would rise to 25%.

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

The firm is forecasting retained earnings of $300,000 for the coming year.

Question:

j.       (1)     What is Coleman’s overall, or weighted average, cost of capital ( WACC) when retained earnings are used as the equity component?

(2)     What is the WACC after retained earnings have been exhausted and Coleman uses up to $300,000 of new common stock with a 15% flotation cost?

Answer 1

1)
Equity
Cost of equity
Risk Free Rate (Rf)	7.00%
Beta	1.2
Market Risk Premium(MRP)	6.00%
Cost of equity(Re = Rf + Beta x MRP =	14.20%
Debt
FV	$1,000.00
Coupon Payment =$1000 x 12%/2	$60.00
PV	$1,153.72
Period = 15 x2	30
YTM = Rate(30,60,-1153.72,1000)	5.00%
Annual Rate = 5% x 2	10.00%
After Tax = 10% x (1-40%)	6.00%
Preferred
Cost of Preferred = ($100 x 10%)/($113.10 - $2)	9.00%
WACC	Weights	Cost	Weights x Cost
Equity	60.00%	14.20%	8.52%
Debt	30.00%	6.00%	1.80%
Preferred	10.00%	9.00%	0.90%
		WACC	11.22%
2)
Equity
D0	$4.19
Growth Rate(g)	5.00%
Price (P0)	$50.00
Floatation Cost	15.00%
Cost of Equity = (D1/P0) - f )+ g
Cost of Equity = [($4.19 x (1+5%))/($50 - $50 x 15%) ]+ 5%	15.35%
Debt
FV	$1,000.00
Coupon Payment =$1000 x 12%/2	$60.00
PV	$1,153.72
Period = 15 x2	30
YTM = Rate(30,60,-1153.72,1000)	5.00%
Annual Rate = 5% x 2	10.00%
After Tax = 10% x (1-40%)	6.00%
Preferred
Cost of Preferred = ($100 x 10%)/($113.10 - $2)	9.00%
WACC	Weights	Cost	Weights x Cost
Equity	60.00%	15.35%	9.21%
Debt	30.00%	6.00%	1.80%
Preferred	10.00%	9.00%	0.90%
		WACC	11.91%