Assume that you were recently hired as assistant to Jerry Lehman, financial VP o
ID: 2790258 • 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
J1. Computation of WACC:
Weights
Cost of capital
WACC
Equity
0.6
14%
8.4%
Preferred stock
0.1
9%
0.9%
Debt
0.3
6%
1.8%
Total
1
11.1%
Notes:
we need to find the cost of funds. We have the information available to calculate the cost of equity using the CAPM, so:
RE = 7% + 1.2(6%) =14.2%
Since Colman is a constant growth stock, Re can be calculated as:
RE = D1 / P0 = 4.109+5%/ $50 + 5%
= 4.4 / 50 + 5% = 13.8%
Average = (14.2% + 13.8%) / 2 = 14% is the cost of equity
The cost of debt is the YTM of the company’s outstanding bonds, so:
P0 = $1153.72= $60(PVIFAR%,30) + $1,000(PVIFR%,30)
R = 5%
YTM = 5% × 2 = 10%
And the after tax cost of debt is:
RD = (1 – 40%)(.010) = 6%
The cost of preferred stock is:
RP = $10/$113.1- 2 =9%
J2. Computation of WACC: (coleman uses upto $300,000 of new common stock):
Weights
Cost of capital
WACC
Equity
0.6
15.4%
9.24%
Preferred stock
0.1
9%
0.9%
Debt
0.3
6%
1.8%
Total
1
11.94%
Here, Up to $300,000 of new stock sold , the WACC increases from 11.1% to 12.1%
Weights
Cost of capital
WACC
Equity
0.6
14%
8.4%
Preferred stock
0.1
9%
0.9%
Debt
0.3
6%
1.8%
Total
1
11.1%