Question

Given the following data:

1. The firm’s marginal tax rate is 21%.
2. The current price of the corporation’s 10% coupon, semiannual payment, noncallable bonds with 15 years remaining to maturity is $1,011.55. The company 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 $110.12. The company would incur flotation costs of $3 per share on a new issue.
4. The company’s common stock is currently selling at $55 per share. Its last dividend (D₀) was $4.99, and dividends are expected to grow at a constant rate of 4.8% in the foreseeable future. The company’s beta is 1.1, the yield on Treasury bonds is 4%, and the market risk premium is estimated to be 7%. For the bond-yield-plus-risk-premium approach, the firm uses a four percentage point risk premium.
5. 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%.
6. The company’s target capital structure is 30 %long-term debt, 10% preferred stock, and 60% common equity.
7. The firm is forecasting retained earnings of $300,000 for the coming year.

Answer the following questions:

a.      (1)     What sources of capital should be included when you estimate Coleman’s weighted average cost of capital (WACC)?

         (2)     Should the component costs be figured on a before-tax or an after-tax basis? Explain.

         (3)     Should the costs be historical (embedded) costs or new (marginal) costs? Explain.

b.      What is the market interest rate on the company’s debt and its component cost of debt?

c.      (1)     What is the firm’s cost of preferred stock?

         (2)     The company’s preferred stock is riskier to investors than its debt, yet the 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 the company’s estimated cost of retained earnings using the CAPM approach?

e.      What is the estimated cost of retained earnings using the discounted cash flow (DCF) approach?

f.       What is the bond-yield-plus-risk-premium estimate for the company’s cost of retained earnings?

g.      What is your final estimate for r_s?

Answer 1

a) 1)

The sources of capital that should be included in estimating the WACC are:-

I) Debt- all interest bearing debt, whether long term or short term

ii) Preferred Stock

iii) Common Equity

a2) The component cost should be on after tax basis since the cash flows to be given out to creditors and investors are after tax cash flows

a3) The costs should be new ( marginal) costs, since WACC should be based on future target capital structure. The costs incurred in raising capital to meet this structure will be new costs.

c) 1) Cost of preferred stock= Annual dividend per share/ Price of preferred stock

                                          = 10% * 100/ 110.12

                                         = 9.08%

c2) No,since the yield to maturity on the bonds is before tax. Both rates should be after tax to be properly compared.

d) This cost associated to retained earning refer to the required rate of return or growth of retained earning. The firm needs to earn the same rate of return on retained earnings as the stockholders could earn on alternative investments of similar risk.

d2) Cost of retained earning using CAPM approach

cost= Risk free rate+ stock beta( market risk premium)

= 4% + 1.1( 7%)

=   11.7%

As more space is not available, only this much answer is possible in one go.