Colin was recently hired by Coleman Electronics as a junior budget analyst. He i
ID: 2649050 • Letter: C
Question
Colin was recently hired by Coleman Electronics as a junior budget analyst. He is working for the Venture Capital Division and has been given for capital budgeting projects to evaluate. He must give his analysis and recommendation to the capital budgeting committee.
Colin has a B.S. in accounting from XXX (2007) and passed the CPA exam (2008). He has been in public accounting for 2 years. During that time he earned an MBA from Seattle U. He would like to be the CFO of a company someday--maybe Coleman Electronics-- and this is an opportunity to get onto that career track and to prove his ability.
As Colin looks over the financial data collected, he is trying to make sense of it all. He already has the most difficult part of the analysis complete -- the estimation of cash flows. Through some internet research and application of finance theory, he has also determined the firm
Explanation / Answer
1. Calculation of Cost of Debt: For this we have to calculate Yield to Maturity.
Formula to Calculate Yield to Maturity:
Bond Price = Par Value x Coupon Rate x 1 - (1 + r) -mxn / r + Par Value / (1+ r) mxn
YTM= r x m
Where,
r = Rate of Return = X, m = Number of Coupons in a Year = 2, n = Number of Years = 8 Years, Bond Price = $990
Par Value = 1,000 Coupon Rate = 10% / 2 = 5%
990 = 1,000 x 0.05 x 1 - (1+ X) -2 x 8 / X + 1,000 / (1+ X) 2 x 8
YTM = 10.19%
So, Cost of debt is 10.19%
After Tax Cost of debt = 10.19 x (1 - Tax Rate)
After Tax Cost of Debt = 10.19 x (1 - 0.35) = 6.62%
2. Cost of Preferred Stock = Dividend / Price
Dividend on Preferred Stock = 100 x 10% = $10, Price = $105
Cost of Preferred Stock = 10 / 105 = 9.52%
3. Calculation of Cost of Equity using the CAPM Approach:
Cost of Equity = rf + Beta (Market Portfolio Return - Risk Free Return)
rf = Risk Free Rate,
Given, rf = 2.5%, Beta = 1.2, Market Portfolio Return = 12%
Cost of Equity = 0.025 + 1.2 (0.12 - 0.025)
Cost of Equity = 13.90%
4. Cost of Equity using the DCF Approach:
Cost of Equity = D1 / P0 + Growth Rate
D1 = Dividend next Year, P0 = Price,
D1 = 3 x 0.06 + 3 = $3.18, P0 = $36, Growth Rate = 6%
Cost of Equity = 3.18 / 36 + 0.06 = 14.83%