Assume that you were recently hired as assistant to Jerry Lehman, financial VP o
ID: 2790255 • 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 fiotation 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
1)
Earnings can be paid as dividends or invested back into the business (retained earnings). Coleman should earn more on retained earnings than stockholders would have earned on dividend received (which they invest on other assets). Hence retained earnings come with a opportunity cost which is equal to cost of equity.
2)
CAPM
Re = Rf + beta * Market risk premium
Re = 7% + 1.2*6%
= 7% + 7.2%
= 14.2%