Question

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

A1) The sources of capital are debt, preferred stock, common stock and retained earnings in wacc.

A2) The components cost should be taken on after tax basis, because tax decreases the cost of raising the capital by providing decduction while calculating profit , leading to increase in cash flow.

A3) The cost should be new marginal cost as it provides the current information of the market and the investors demand market required rate of return . So, the wacc should be calculated using new marginal cost.

B1) Using financial calculator to calculate, the cost of debt before tax

Inputs: N= 15 × 2 = 30 (semiannual)

Pmt= 10% /2 × 1,000 = 5% × 1,000 = 50

Pv= -1,011.55

Fv= 1,000

I/y= compute

We get, ytm of the bond before tax as 4.9255% × 2 (semiannual) = 9.8510%

After tax Cost of Debt= 9.8510% (1-0.21)

= 9.8510% × 0.79

= 7.7823%

C1) Cost of preferred stock = Annual dividend/ price - floatation cost

= 10% × 100 / 110.12 - 3

= 10 / 107.12

= 9.34%

C2) The cost of preferred stock is more than cost of debt, because it is more riskier than debt. But the yield to investors is lowee than yield to maturity because, yield to maturity is not adjusted for tax where as yield to investor is calculated after tax.

D1) The amount of money kept as retained earnings by the company could have had been invested by the shareholders at a higher rate than the company. So there is a cost related to retained earning, which is a kind of opportunity cost.

D2) Expected return= Risk free rate + beta (market risk premium)

= 4% + 1.1 (7%)

= 4% + 7.7%

= 11.7%