Cost of Capital - WACC - Theory.
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.
To structure the task somewhat, Lehman has asked you to answer the following questions.
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?
b.What is the market interest rate on Coleman's debt and its component cost of debt?
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.)
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?
e.What is the estimated cost of common equity using the DCF approach?
f.What is the bond-yield-plus-risk-premium estimate for Coleman's cost of common equity?
g.What is your final estimate for?
h.Explain in words why new common stock has a higher cost than retained earnings.
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 percent. Coleman incorporates the flotation costs into the DCF approach. What is the estimated cost of newly issued common stock, considering the flotation cost?
j. What is Coleman's overall, or weighted average, cost of capital (WACC)? Ignore flotation costs.
k. What factors influence Coleman's composite WACC?
l. Should the company use the composite WACC as the hurdle rate for each of its projects? Explain.