Analysis of variances in cost of common equity and cost of retained earnings.
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 cost of capital. Assume that 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.
1) The firm's tax rate is 40 percent.
2) The current price of Coleman's 12 percent 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.
3) The current price of the firm's 10 percent, $100 par value, quarterly dividend, perpetual preferred stock is $111.10.
4) Coleman's common stock is currently selling for $50 per share. Its last dividend (D_0) was $4.19, and dividends are expected to grow at a constant rate of 5 percent in the foreseeable future. Coleman's beta is 1.2, the yield on T-bonds is 7 percent, and the market risk premium is estimated to be 6 percent. For the bond-yield-plus-risk-premium approach, the firm uses a risk premium of 4 percent.
5) Coleman's target capital structure is 30 percent debt, 10 percent preferred stock, and 60 percent common equity.
Explain in words why new common stock has a higher cost than retained earnings.