Assume that you were recently hired as assistant to Jerry Lehman, financial VP o
ID: 2790254 • Letter: A
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: (1) The firm's marginal tax rate is 40%. (2) 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. (3) 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. (4) Coleman's common stock is currently selling at $50 per share. Its last dividend (Do) 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 rmarket risk premium is estimated to be 6%. 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) Coleman'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.Explanation / Answer
Since the companies equity is already floating in the market and the flotation cost is high, the cost of equity would be calculated using the following:
Cost of Equity = ((Dividend)/Price*(1-Flotation cost) + Growth Rate
( ((4.19)/$50*(1-15%))+5%) = 15%
Since the interest pain on bonds are tax deductibe, we will adjust the interest for tax rate
Cost of non callable bonds = Interest on bond * (1-Tax Rate)
=12%*(1-40%) = 7.2%
Cost of Preferred Shares = ((dividend/Price (1-flotattion cost))
=(10/100*(1-(2/100)) = 10.20%
A. 1. WACC = (Cost of Equity*Share of Equity)+ (Cost of Preferred Equity*Share of PreferredEquity) + (Cost of Debt *Share of Debt)
(15%*60%)+(7.2%*30%)+(10%*10%) = 12.18%
2. Since interest payment on debt is tax deductible, only debt component wuld be post tax
B.
1153.72 =((1000/2) (1-(1+ytm/2) ^ -2(15))/ (ytm/2)) + ((1000/ (1+ytm/2)^2(15))
= 10%
Cost of Debt as calculated before = 7.2%