Question: Mannheim Biotechnology Limited is expanding the business by considering investing in some profitable projects. Stevenson, a project manager of Mannheim was asked to estimate the cost of capital and evaluate the following projects:
Table 1: Projected Cash Flows (in millions)
|
Year
|
0
|
1
|
2
|
3
|
4
|
|
Project A
|
(100.00)
|
10.00
|
50.00
|
40.00
|
20.00
|
|
Project B
|
(200.00)
|
80.00
|
90.00
|
85.00
|
10.00
|
|
Project C
|
(300.00)
|
105.00
|
90.00
|
110.00
|
20.00
|
Albert, the Chief Financial Officer (CFO) of Mannheim hooprovided him some relevant infomiation.
1. The current bond price of Mannheirn's 10% coupon, semiannual payment with 10 years left to maturity is $1.134.20. The par value of the bond is $1,000. The company' s tax rate is 40%.
2. The current price of the preferred stock is $31.25 with annual dividend payment of $3.75.
3. Mannheim, common stock is currently selling for $45 per share. Its last dividend payment was 53.25 and dividend is expected to grow at a constant rate of 3% in the foreseeable future. Mannheim's beta is 1.2, the risk free rate is 6%. and the market risk premium is estimated to be 4%. For the bondryield-plus-risk-premium approach. the firm uses a risk premium of 4% with the yield on the Treasury bond of 6.5%.
Sharron, a finance manager of Mannheim, has $400 million capital available consisting of $160 million debt, $140 preferred stock, and $100 million common stock.
Albert asked Stevenson to prepare a report answering the following questions:
a. What are the sources of capital to be included when estimating the Mannheim's WACC? In calculating the WACC, if he had to use book values for either debt or equity, which would he thoose? Why?
b. What is the cost of debit after tax?
c. What is the firm's cost of preferred stock?
d. Explain why there is a cost of retained earnings?
e. What is Mannheim's estimated cost of common equity using the CAPM approach?
f. What is the estimated cost of common equity using the DCF approach?
g. What is the bond-yield-plus-risk-premiurn estimate for Mannheirn's cost of comrnon equity?
h. Who is your final estimate for r, or the average required rate of retum?
i. Explain in words why new common stock has a higher cost than retained earnings.
j. Mannheim estimates that if it issues new common stock, the flotation cost will be 20%. Mannheim incorporates the flotation costs into the DCF approach. What is the estimated cost of newly issued common stock. considering the flotation cost?
k. What is Mannheim's overall, or weighted average, cost of capital (WACC)? Ignore flotation costs.
l. Who are the factors affecting Mannheim's composite WACC?