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Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977
Textbook Problem

COLEMAN TECHNOLOGIES INC.

10-22 COST OF CAPITAL Coleman Technologies is considering a major expansion program that has been proposed by the company’s information technology group. Before proceeding with the expansion, the company must estimate its cost of capital. Suppose you are an assistant to Jerry Lehman, the financial vice president. Your first task is to estimate Coleman’s cost of capital. Lehman has provided you with the following data, which he believes may be relevant to your task.

  • The firm’s tax rate is 40%.
  • The current price of Coleman’s 12% coupon, semiannual payment, noncallable bonds with 15 years remaining to maturity, is $1,153.72. Coleman does not use short-term, interest-bearing debt on a permanent basis. New bonds would be privately placed with no flotation cost.
  • The current price of the firm’s 10%, $100.00 par value, quarterly dividend, perpetual preferred stock is $111.10.
  • Coleman’s common stock is currently selling for $50.00 per share. Its last dividend (D0) was $4.19, and dividends are expected to grow at a constant annual rate of 5% in the foreseeable future. Coleman’s beta is 1.2, the yield on T-bonds is 7%, and the market risk premium is estimated to be 6%. For the bond-yield-plus-risk-premium approach, the firm uses a risk premium of 4%.
  • Coleman’s target capital structure is 30% debt. 10% preferred stock, and 60% common equity.

To structure the task somewhat. Lehman has asked you to answer the following questions.

  1. a. 1. What sources of capital should be included when you estimate Coleman's WACC?

2. Should the component costs be figured on a before-tax or an after-tax basis?

3. Should the costs be historical (embedded) costs or new (marginal) costs?

  1. b. What is the market interest rate on Coleman’s debt and its component cost of debt?
  2. c. 1. What is the firm's cost of preferred stock?

2. Coleman's preferred stock is riskier to investors than its debt, yet the preferred's yield to investors is lower than the yield to maturity on the debt. Docs this suggest that you have made a mistake? (Hint: Think about taxes.)

  1. d. 1. Why is there a cost associated with retained earnings?

2. What is Coleman’s estimated cost of common equity using the CAPM approach?

  1. e. What is the estimated cost of common equity using the DCF approach?
  2. f. What is the bond-yield-plus-risk-premium estimate for Coleman's cost of common equity?
  3. g. What is your final estimate for rs?
  4. h. Explain in words why new common stock has a higher cost than retained earnings.
  5. i. 1. What are two approaches that can be Used to adjust for flotation costs?

2. Coleman estimates that if it issues new common stock, the flotation cost will be 15%. Coleman incorporates the flotation costs into the DCF approach. What is the estimated cost of newly issued common stock, considering the flotation cost?

  1. j. What is Coleman’s overall, or weighted average, cost of capital (WACC)? Ignore flotation costs.
  2. k. What factors influence Coleman’s composite WACC?
  3. l. Should the company use the composite WACC as the hurdle rate for each of its projects? Explain.

a.

1.

Summary Introduction

To determine: The sources of capital should be included while estimating WACC.

Introduction:

Cost of Capital:

In any company, there is need of the fund for various purposes. The companies raise capital through various sources such as equity, debt and preferred stock. The cost of capital is the total cost of raising capital. It consists of the cost of debt, cost of equity, and cost of preferred stock.

Weighted Average Cost of Capital:

It is the weighted average cost of capital of all the sources through which firm finances its capital. It is that rate that company will pay to all for raising finance. It can be termed as firm’s cost of capital. The company raises money through various sources such as common stock, preference share debt the WACC is calculated taking the relative weight of each item of capital structure.

Explanation
  • The fixed amount of interest is paid to non-callable bonds...

2.

Summary Introduction

To discuss: The component cost should be figured on before-tax or an after-tax basis.

3.

Summary Introduction

To discuss: The cost should be historical (embedded cost or new (marginal) costs.

b.

Summary Introduction

To determine: The market interest rate in C company debt and its component cost of debt.

Introduction:

Yield to Maturity

The rate of return which is received by the bondholder if the bonds are held up to the ending year is called Yield to maturity.

After-Tax Cost of Debt

It can be defined as the relevant cost of new debt considering tax deductibility in interest. It is the cost of debt after tax savings. The interest on the debt is tax deductible. The tax can save on the interest paid on the debt. It is used to calculate the weighted average cost of capital.

c.

1.

Summary Introduction

To determine: The firm’s cost of preferred stock.

Introduction:

Cost of Preferred Stock

The return earned by of firm’s preferred stockholders from the investment in preferred stock is a cost of preferred stock. It is computed by dividing dividend received on preferred stock by the current price of the preferred stock

2.

Summary Introduction

To determine: The selection of the riskier investment in preferred stock which yields less return to investors in comparison is a mistake or not.

d.

1.

Summary Introduction

To determine: The reason for cost associated with retained earnings.

Introduction:

Cost of Retained Earnings

The Company can raise its capital by issuing new shares by retaining its current earnings. The companies normally retain a certain percentage of their earnings and after some time it is invested by the company. The cost is retained earnings is determined on the basis of opportunity cost principle.

Capital Assets Pricing Model (CAPM)

As per this approach, the equity cost is the required return to the investors which is minimum return expected by the investors to take an additional risk. This can be calculated by adding the risk premium to the risk-free rate. The risk premium is the cost of taking additional risk. The formula of cost of equity as per this approach is:

rs=rRF+(rMrRF)bi

Where,

  • rs is the rate of return on the stock
  • rRF is the is risk-free return.
  • rM is the market rate of return
  • bi is the beta of security

2.

Summary Introduction

To determine: The cost of common equity using CAPM approach.

(e)

Summary Introduction

To determine: The estimated cost of equity using the DCF approach.

Introduction:

DCF Approach

In this approach, the value of the stock of the company is the present value of its all cash flows discounted at the required return of the investors. The formula to find the cost of equity assuming the expected growth rate constant is:

r=D1P0+g

Where

  • D1 is the next expected dividend
  • P0 is the current price of the stock
  • g is the constant growth rate.

f.

Summary Introduction

To determine: The estimated cost of equity using bond-yield-plus-risk-premium.

Introduction:

Bond-Yield-Plus-Risk-Premium

As per this approach, the cost of equity is the total of the bond yield and risk premium.

g.

Summary Introduction

To determine: The final estimate for rs

(i)

1.

Summary Introduction

To determine: The two approaches that can be used to adjusted for flotation costs.

Introduction:

Flotation Cost

The cost which occurred when the new shares are issued by the company is called floatation cost. It increases the cost of newly issued shares.

2.

Summary Introduction

To determine: The projected cost of newly issued common stock, considering flotation cost.

(j)

Summary Introduction

To determine: The overall, or weighted average, cost of capital (WACC).

k.

Summary Introduction

To identify: The factors which influence C company composite WACC.

l.

Summary Introduction

To identify: The Company should use the composite WACC as the hurdle rate each of its projects.

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