During the last few years, Coleman Technologies has been too constrained by the

Question

During the last few years, Coleman Technologies has been too constrained by the high cost of capital to make many capital investments. Recently, though, capital costs have been declining, and the company has decided to look seriously at a major expansion program that had been proposed by the marketing department. 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 he believes may be relevant to your task:


(1) The firm’s tax rate is 40%.
(2) 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 floatation cost.
(3) The current price of the firm’s 10%, $100 par value, quarterly dividend, perpetual preferred stock is $113.10. Coleman would incur floatation costs of $2.00 per share on a new issue.
(4) 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 1.02; 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 4% risk premium.
(5) New common stock can be sold at a floatation cost of 15%.
(6) Coleman’s target capital structure is 30% long-term debt, 10% preferred stock, and 60% common equity.
(7) 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 source of capital should be included when you estimate Coleman’s WACC?
(2) Should the component costs be figured on a before-tax or an after-tax basis? 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?

Explanation / Answer

A.) The cost of the bonds, preferred stock, common stock and retained earnings should be included in the WACC.

2.) The component cost should be based on an after-tax cost basis since the use of debt provides an interest tax shield.

b.) Rate on debt:
1153.72 CHS PV
1000 FV
60 PMT
30 n
2x i = 10.00 %

Component cost of debt:
30%(target debt) * 10.00% * (1-0.4) = 1.8%

C)
Cost of preferred stock:

Price = Div/rate
113.10 = 10/r
r = 0.088 or 8.8%

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