1. The firms tax rate is 40% 2. The current price of Colemans 12% coupon, semian
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Question
1. The firms tax rate is 40%2. The current price of Colemans 12% coupon, semiannual payment, noncallable bonds with 15 years remaining to maturity is $ 1153.72. 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 firms 10 % $100.00 par value, quarterly dividend, prepetual preffered stock is $111.10
4. Colemans current stock is selling for $50 per share. Its last dividend was $4.19 and dividends are expected to grow at a constant rate of 5% in the forseeable future. Colemans beta is 1.2, the yield on T 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 risk premium of 4%.
A. 1- What sources of capital should be included when you estimate the WACC?
2- Should the component costs be figured on a before tax or an after tax basis?
3- Should the costs be historical costs or new costs?
B- what is the market intreest rate on colemans debt and its component cost of debt
c- 1- what is the firms cost of preffered stock?
d- 1- why is there a cost associated with retained earnings?
2- what is colemans estimated cost of common equity using the CAPM approach?
Explanation / Answer
1. A. 1- What sources of capital should be included when you estimate the WACC?
The WACC is used primarily for making long-term capital investment decisions, i.e., for capital budgeting. Thus, the WACC 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 accruals 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 rather than gross working capital is included in capital expenditures.
2- Should the component costs be figured on a before tax or an after tax basis?
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 basis
3- Should the costs be historical costs or new costs?
In financial management, the cost of capital is used primarily to make decisions which involve raising new capital. Thus, the relevant component costs are today's marginal costs rather than historical costs.
B- What is the market interest rate on Coleman’s debt and its component cost of debt
rd (1 - T) = 10.0%(1 - 0.40)
= 10.0 %( 0.60)
= 6.0%.
c- 1- what is the firms cost of preferred stock?
Since the preferred issue is perpetual, its cost is estimated as follows:
rps = Dps/Pn
= 0.1($100) / $133.10 - $2.00
d- 1- why is there a cost associated with retained earnings?
Management may either pay out earnings in the form of dividends or else retain earnings for reinvestment in the business. If part of the earnings is retained, an opportunity cost is incurred: stockholders could have received those earnings as dividends and then invested that money in stocks, bonds, real estate, and so on.
2- What is Coleman’s estimated cost of common equity using the CAPM approach?
rs = 0.07 + (0.06)1.2
= 14.2%.
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