Coleman Technologies is considering a major expansion program that has been proposed by the company’sinformation technology group. Before proceeding with the expansion, the company needs to develop an estimateof its 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 hebelieves 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 selling for $50.00 per share,. It’s last dividend (D0)was $4.19, and dividends are expected to grow at a constant rate of 5 percent in the foreseeablefuture. 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 4 percentage point risk premium.
(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
- (1) What sources of capital should be included when you estimate Coleman’s WACC?
(2) . Should the component be figured on a before-tax or an after tax basis?
(3) Should the costs be historical (embedded) costs or new marginal) costs?
- What is the market interest rate on Coleman’s debt and its component cost of debt?
- (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.)
- (1) Why is there a cost associated with retained earnings?
(2) What is Coleman’s estimated cost of common equity using the DCF approach?
G. What is your final estimate for Rs?
H. Explain in words why new common stock has a higher cost than retained earnings.
J. What is Coleman’s overall, or weighted average, cost of capital (WACC)? Ignore flotation costs.
K. What factors influence Coleman’s composite WACC? D. (1) Why is there a cost associated with retained earnings?
(2) What is Coleman’s estimated cost of common equity using the DCF approach?
G. What is your final estimate for Rs?
H. Explain in words why new common stock has a higher cost than retained earnings.
J. What is Coleman’s overall, or weighted average, cost of capital (WACC)? Ignore flotation costs.
K. What factors influence Coleman’s composite WACC? - Should the company use the composite WACC as the hurdle rate for each of its projects? Explain.
- (1) What sources of capital should be included when you estimate Coleman’s WACC?
Basically WACC is used for making long-term capital investment decisions like for capital budgeting.It should include the types of capital used to pay for long-term assets, and this is typically long-term debt, preferred stock (if used), and common stock. Short-term sources of capital consist of (1) spontaneous, noninterest-bearing liabilities such as accounts payable and accrued liabilities and (2) short-term interest-bearing debt, such as notes payable. If the firm uses short-term interest-bearing debt to acquire fixed assets rather than just to finance working capital needs, then the WACC should include a short-term debt component. Noninterest-bearing debt is generally not included in the cost of capital estimate because these funds are netted out when determining investment needs, that is, net operating rather than gross operating working capital is included in capital expenditures.
- (2) Should the component costs be figured on a before-tax or an after-tax basis?
Answer: [Show S10-4 here.] Stockholders are concerned primarily with those corporate cash flows that are available for their use, namely, those cash flows available to pay dividends or for reinvestment. Since dividends are paid from and reinvestment is made with after-tax dollars, all cash flow and rate of return calculations should be done on an after-tax basis.
- (3) Should the costs be historical (embedded) costs or new (marginal) costs?
Answer: [Show S10-5 and S10-6 here.] In financial management, the cost of capital is used primarily to make decisions that involve raising new capital. Thus, the relevant component costs are today’s marginal costs rather than historical costs.
- What is the market interest rate on Coleman’s debt and its component cost of debt?
Answer: [Show S10-7 through S10-9 here.] Coleman’s 12% bond with 15 years to maturity is currently selling for $1,153.72. Thus, its yield to maturity is 10%:
0 1 2 3 29 30
| | | | · · · | |
-1,153.72 60 60 60 60 60
1,000
Enter N = 30, PV = -1153.72, PMT = 60, and FV = 1000, and then press the I/YR button to find rd/2 = I/YR = 5.0%. Since this is a semiannual rate, multiply by 2 to find the annual rate, rd = 10%, the pre-tax cost of debt.
Since interest is tax deductible, Uncle Sam, in effect, pays part of the cost, and Coleman’s relevant component cost of debt is the after-tax cost:
rd(1 – T) = 10.0%(1 – 0.40) = 10.0%(0.60) = 6.0%.
- (1) What is the firm’s cost of preferred stock?
Answer: [Show S10-10 and S10-11 here.] Since the preferred issue is perpetual, its cost is estimated as follows:
rp = = = = 0.090 = 9.0%.
Note (1) that since preferred dividends are not tax deductible to the issuer, there is no need for a tax adjustment, and (2) that we could have estimated the effective annual cost of the preferred, but as in the case of debt, the nominal cost is generally used.
- (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.)
Answer: [Show S10-12 and S10-13 here.] Corporate investors own most preferred stock, because 70% of preferred dividends received by corporations are nontaxable. Therefore, preferred often has a lower before-tax yield than the before-tax yield on debt issued by the same company. Note, though, that the after-tax yield to a corporate investor and the after-tax cost to the issuer are higher on preferred stock than on debt.
- (1) Why is there a cost associated with retained earnings?
Answer: [Show S10-14 through S10-16 here.] Coleman’s earnings can either be retained and reinvested in the business or paid out as dividends. If earnings are retained, Coleman’s shareholders forgo the opportunity to receive cash and to reinvest it in stocks, bonds, real estate, and the like. Thus, Coleman should earn on its retained earnings at least as much as its stockholders themselves could earn on alternative investments of equivalent risk. Further, the company’s stockholders could invest in Coleman’s own common stock, where they could expect to earn rs. We conclude that retained earnings have an opportunity cost that is equal to rs, the rate of return investors expect on the firm’s common stock.
- (2) What is Coleman’s estimated cost of common equity using the CAPM approach?
Answer: [Show S10-17 here.] The CAPM estimate for Coleman’s cost of common equity is 14.2%:
rs = rRF + (rM – rRF)b
= 7.0% + (6.0%)1.2 = 7.0% + 7.2% = 14.2%.
- What is the estimated cost of common equity using the DCF approach?
Answer: [Show S10-18 through S10-20 here.] Since Coleman is a constant growth stock, the constant growth model can be used:
= = =
= + 0.05 = 0.088 + 0.05 = 8.8% + 5.0% = 13.8%.
- What is the bond-yield-plus-risk-premium estimate for Coleman’s cost of common equity?
Answer: [Show S10-21 here.] The bond-yield-plus-risk-premium estimate is 14%:
rs = Bond yield + Risk premium = 10.0% + 4.0% = 14.0%.
Note that the risk premium required in this method is difficult to estimate, so this approach only provides a ballpark estimate of rs. It is useful, though, as a check on the DCF and CAPM estimates, which can, under certain circumstances, produce unreasonable estimates.
- What is your final estimate for rs?
Answer: [Show S10-22 here.] The following table summarizes the rs estimates:
Method Estimate
CAPM 14.2%
DCF 13.8
rd + rp 14.0
Average 14.0%
At this point, considerable judgment is required. If a method is deemed to be inferior due to the “quality” of its inputs, then it might be given little weight or even disregarded. In our example, though, the three methods produced relatively close results, so we decided to use the average, 14%, as our estimate for Coleman’s cost of common equity.
- Explain in words why new common stock has a higher cost than retained earnings.
Answer: [Show S10-23 here.] The company is raising money in order to make an investment. The money has a cost, and this cost is based primarily on the investors’ required rate of return, considering risk and alternative investment opportunities. So, the new investment must provide a return at least equal to the investors’ opportunity cost.
If the company raises capital by selling stock, the company doesn’t receive all of the money that investors contribute. For example, if investors put up $100,000, and if they expect a 15% return on that $100,000, then $15,000 of profits must be generated. But if flotation costs are 20% ($20,000), then the company will receive only $80,000 of the $100,000 investors contribute. That $80,000 must then produce a $15,000 profit, or a $15/$80 = 18.75% rate of return versus a 15% return on equity raised as retained earnings.
- (1) What are two approaches that can be used to adjust for flotation costs?
Answer: The first approach is to include the flotation costs as part of the project’s up-front cost. This reduces the project’s estimated return. The second approach is to adjust the cost of capital to include flotation costs. This is most commonly done by incorporating flotation costs in the DCF model.
- (2) Coleman estimates that if it issues new common stock, the flotation cost will be 15%. Coleman incorporates the flotation costs into the DCF approach. What is the estimated cost of newly issued common stock, considering the flotation cost?
Answer: [Show S10-24 and S10-25 here.]
re = + g
= + 5.0%
= + 5.0% = 15.35%.
- What is Coleman’s overall, or weighted average, cost of capital (WACC)? Ignore flotation costs.
Answer: [Show S10-26 here.] Coleman’s WACC is 11.1%.
A-T
Capital Structure Component
Weights ´ Costs = Product
0.3 6% 1.8%
0.1 9 0.9
0.6 14 8.4
1.0 WACC = 11.1%
WACC = wdrd(1 – T) + wprp + wcrs
= 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%)
= 1.8% + 0.9% + 8.4% = 11.1%.
- What factors influence Coleman’s composite WACC?
Answer: [Show S10-27 here.] There are factors that the firm cannot control and those that they can control that influence WACC.
Factors the firm cannot control:
|
Interest rates
Tax rates
Factors the firm can control:
Capital structure policy
Dividend policy
Investment policy
- Should the company use the composite WACC as the hurdle rate for each of its projects? Explain.
Answer: [Show S10-28 here.] No. The composite WACC reflects the risk of an average project undertaken by the firm. Therefore, the WACC only represents the “hurdle rate” for a typical project with average risk. Different projects have different risks. The project’s WACC should be adjusted to reflect the project’s risk.
