Integrative Case 4: Eco Plastics Company. Source of Capital: Long-term debt 30%,

Question

Integrative Case 4: Eco Plastics Company. Source of Capital: Long-term debt 30%, Preferred Stock 20%, Common Stock Equity 50%. Eco can raise debt by selling 20 year bonds with $1,000 pr value and a 10.5% annual coupon interest rate. Eco's corporate tax rate is 40%, and its bonds generally require an average discount of $45 per bond and flotation costs of $32 per bond when being sold. Eco's outstanding preferred stock pays a 9% dividend and has a $95-per-share par value. The cost of issuing and selling additional preferred stock is expected to be $7 per share. Because Ecdo is a young firm that requires lots of cash to grow it does not currently pay a dividen to common stockholders. To track the cost of common stock the CFO uses the capital asset pricing model (CAPM). THe CFO and the firm's investment advisors believe that the appropriate risk-free rate is 4% and that the market's expected return equals 13%. Using data from 2012 through 2015, ECO's CFO estimates the firm's beta to be 1.3. Although ECO's current target capital structure includes 20% preferred stock, the company is considering using debt financing to retire the outstanding preferred common stock. If Eco shits its capital its capital mix from preferred stock to debt, its financial advisors expect is beta to increase to 1.5. (a) Calculate Eco's current after-tax cost of long-term debt. (b) Calculate Eco's current cost of preferred stock. (c) Calculate Eco's current cost of common stock. (d) Calculate Eco's current weighted average cost of capital. (e1) Assuming that the debt financing costs do not change, what effect would a shift to a more highly leveraged capital structure consisting of 50% long-term debt, 0% preferred stock, and 50% common stock have on the risk premium for Eco's common stock? What would be Eco's new cost of common equity? (e2) What would be Eco's new weighted average cost of capital? (e3) Which capital structure - the original one or this one - seems better? Why?

Explanation / Answer

a. Calculation of current cost of Debt:

Cost of Debt = Annual Coupon / Sale Proceeds from the issue of bonds

Annual Coupon = 1,000 x 10.5% = 105 x (1 - 0.40) = $63

Sale Proceeds of new bonds = 1,000 - 45 - 32 = 923

Cost of Debt = 63 / 923 = 6.83%

b. Calculation of cost of Preferred Stock = Dividend / Market Price - Flotation cost of Prefer stock

Cost of Prefer Stock = 9 / 95 - 7 =10.23%

c. Calculation of Cost of Equity:

Cost of Equity = rf + Beta (rm - rf)

rf = Risk Free Rate of return = 4% rm = Market expected return = 13% Beta = 1.3

Cost of Equity = 0.04 + 1.3 (0.13 - 0.04) = 15.70%

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