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Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250
Textbook Problem

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 $lll-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?

  2. b. What is the market interest rate on Coleman's debt and its component cost of debt?
  3. 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. Does this suggest that you have made a mistake? (Hint: Think about taxes.)

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

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

  5. e. What is the estimated cost of common equity using the DCF approach?
  6. f. What is the bond-yield-plus-risk-premium estimate for Coleman's cost of common equity?
  7. g. What is your final estimate for r?
  8. h. Explain in words why new common stock has a higher cost than retained earnings.
  9. 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?

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

a1.

Summary Introduction

To determine: The sources of capital that must be included when estimating Company C’s WACC.

Introduction: WACC is abbreviated as weighted average cost of capital, is an equation that computes the average rate of return that an organization requires to acquire to repay its security holders or investors. This computation is utilized to determine if a project is beneficial or in the event that it just repays the expense of subsidizing the project.

Explanation

The capital sources that must be included when estimating Company C’s WACC are as follows:

The weighted average cost of capital (WACC) is utilized fundamentally building the long term capital investment decisions such as for capital budgeting. Hence, the WACC ought to incorporate the form of capital that is utilised to pay for the long term assets, and this is ordinarily interest bearing debt, preferred stock whenever utilized, and common stock. The total debt comprises of both long term and short term interest bearing debt...

a2.

Summary Introduction

To Determine: Whether the component costs is figured on before-tax or on after-tax basis.

a3.

Summary Introduction

To Determine: Whether the costs are historical costs or new costs.

b.

Summary Introduction

To Determine: The market interest rate on Company C’s stock and its component cost of debt.

c1.

Summary Introduction

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

c2.

Summary Introduction

To Determine: Whether the statement on the preferred stock’s yield to investors is lesser than the yield to maturity on debt is appropriate.

d1.

Summary Introduction

To Determine: The reasons on cost associated with retained earnings.

d2.

Summary Introduction

To Determine: The estimated cost of common equity using CAPM approach.

e.

Summary Introduction

To Determine: The projected cost of common equity utilising DCF approach.

f.

Summary Introduction

To Determine: The bond yield plus risk premium estimate for Company C’s cost of common equity.

g.

Summary Introduction

To Determine: The last estimate of cost of common equity (rs).

h.

Summary Introduction

To Determine: The reasons of why the new common has a larger cost than retained earnings.

i1.

Summary Introduction

To Determine: The two approaches that could be utilised to adjust for flotation costs.

i2.

Summary Introduction

To Determine: The projected cost of newly issued common stock by considering the floatation cost.

j.

Summary Introduction

To Determine: The WACC.

k.

Summary Introduction

To Determine: The factors that influence Company C's composite WACC.

l.

Summary Introduction

To Determine: Whether the company should utilise the composite WACC as hurdle rate for each projects.

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