Assume that you were recently hired as assistant to Jerry Lehman, financial VP of Coleman Technologies. Your first task is to estimate Coleman’s cost of capital. Lehman has provided you with the following data, which he believes is relevant to your task:
The firm’s marginal 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 par value, quarterly dividend, perpetual preferred stock is $113.10. Coleman would incur flotation costs of $2 per share on a new issue.
Coleman’s common stock is currently selling at $50 per share. Its last dividend (D0) was $4.19, and dividends are expected to grow at a constant rate of 5% in the foreseeable future. Coleman’s beta is 1.2, the yield on Treasury 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 four percentage point risk premium.
Up to $300,000 of new common stock can be sold at a flotation cost of 15%. Above $300,000, the flotation cost would rise to 25%.
Coleman’s target capital structure is 30 %long-term debt, 10% preferred stock, and 60% common equity.
The firm is forecasting retained earnings of $300,000 for the coming year.
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 weighted average cost of capital (WACC)?
(2) Should the component costs be figured on a before-tax or an after-tax basis? Explain.
(3) Should the costs be historical (embedded) costs or new (marginal) costs? Explain.
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 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 retained earnings using the CAPM approach?