During the last few years, Agile technologies has been too constrained by the high cost of capital to make many capital investments. Recently, though, money costs have been declining, and the company has decided to look seriously at a major expansion program that had been proposed by the marketing department. Assume that you are an assistant to the VP of Finance. Your first task is to estimate Agile's cost of capital. You have been provided with the following data, which may be relevant to your task:
The firm's tax rate is 40 percent.
The current price of Agile's 14 percent coupon, semiannual payment, noncallable bonds with 16 years remaining to maturity is $1,316.05. Agile 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 10.5 percent, $100 par value, perpetual preferred stock is $116.67. Agile would incur flotation costs of $2.00 per share on a new issue.
Agile's common stock is currently selling at $42.75 per share. Its last dividend (D0) was $3.82, and dividends are expected to grow at a constant rate of 6 percent in the foreseeable future. Agile's beta is 1.26; the yield on t-bonds is 5 percent; and the market risk premium is estimated to be 5.6 percent. For the bond-yield-plus-risk-premium approach, the firm uses a 3 percentage point risk premium. Agile uses all three estimates of the cost of the common equity component in an equally weighted manner. New common stock would incur a flotation cost of 15%.
Agile's target capital structure is 30 percent long-term debt, 10 percent preferred stock, and 60 percent common equity.
The firm is forecasting retained earnings of $600,000 for the coming year.
Answer the following questions:
1. What is Agile's component cost of debt?
2. What is the firm’s cost of preferred stock?
3. What is Agile's estimated cost of retained earnings using the CAPM approach?
4. What is the estimated cost of retained earnings using the discounted cash flow (DCF) approach?
5. What is the bond-yield-plus-risk-premium estimate for Agile's cost of retained earnings?
6. What is your final estimate for Agile’s cost of retained earnings (ks)?
7. What is Agile's overall, or weighted average, cost of capital (WACC) when retained earnings are used as the equity component?
8. What happens to the cost of equity when retained earnings are used up?
9. At what amount of new investment would Agile be forced to issue new common stock?
10. What is the WACC using new common stock?