During the last few years, Coleman Technologies has been too constrained by the
ID: 2666549 • Letter: D
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.
C 2) Coleman’s preferred stock is riskier to investors than its debt, yet the yield to investors is lower than the yield of maturity on the debt. Does this suggest that you have made a mistake? Hint think about the taxes
D 1) Why is there a cost associated with retained earnings?
2) What is Coleman’s estimated cost of retained earnings using the discounted cash flow (DCF) approach?
E) What is the estimated cost of retained earnings using the discounted cash flow(DCF) approach?
F)) What is the bond-yield-plus-risk-premium estimated for Coleman’s cost of retained earnings?
G) What is your final estimate for rs?
Explanation / Answer
C) The pretax cost of debt for the firm is: 1153.72 CHS PV 1000 FV 60 PMT 30 n 2x i = 10.00 % But the after tax cost is only: 10.00% * (1-0.4) = 6% Compared to the preferred stock which is not tax deductible and costs Price = Div/rate 113.10 = 10/r r = 0.088 or 8.8% D) There is a cost associated with retained earnings because it could be paid out as dividends to shareholders and when the firm retain its earnings it must at least earn the WACC on the retained earnings or else the company would destroy shareholder value. E) Ks = Div1/Po + g, --- > 4.19*(1.05)/50 + 0.05 = 0.138 or 13.8% F) Ks = long-term bond yield + risk premium ----> If using government bonds it would be: 7% + 4% = 11% if using the company's bond yield it would be 10% + 4% = 14% G) using CAPM approach we get: 7% + 1.01*(6%) = 13.06%. so the a fair estimate of Rs could be the average of the three (13.8+14+13.06)/3 = 13.62%
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