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: What is Coleman’s cost for up to $300,000 of newly issued common stock, r_e1? What happens to the cost of equity if Coleman sells more than $300,000 of new common stock?

Answer 1

Let us first calculate the cost of debt,

Since the bond is trading at premium, its current yield will be less than its coupon rate.

The bond valuation formula is,

Current value of bond = PV of coupon + PV of fave value

= C1 / (1+YTM)^1 + C2 / (1+YTM)^2+ ...........+ (Cn + Face value) / (1+YTM)^n

Putting values in formula and solving the equiation,

C1,2,3...n = 12% of 1000 = $120

Since the payment is made semi annual, coupon per period will be $60

n = 15 years = 30 semi annual periods

Current value of bond = $1,153.72

we get YTM = 10%

Now

Cost of equity usinf bond yield plus risk premium approach = 7% + 4% = 11%

Cost of preffered stock = Dividend / CP of preffered stock

= 10 / 113.10 = 8.84%

WACC

=

E/

×

re

+

D/

×

(1 ? t)

×

rd

+

P/

×

rp

(E+D+P)

(E+D+P)

(E+D+P)

Where:

E	=	Market value of equity
D	=	Market value of debt
P	=	Market value of preferred stock
re	=	Cost of equity
rd	=	Cost of debt
rp	=	Cost of preferred stock
t	=	Marginal tax rate

WAAC = (10% (1-0.40) *0.30) + (8.84% *0.10) + (11% *0.60)

= 9.28%

(b) The cost of cost of equity if Coleman sells more than $300,000 of new common stock will be same as above since the  Flotation costs are a one time event, incurred only when a company decides to raise capital. Adjusting the cost of capital would be misleading. A more accepted treatment for floation cost is to include it in initial investment amount as a one time cash outflow.