ABC is about to begin its annual capital budgeting process, and the cost of capital is an essential input for capital budgeting decisions. Your team plans to use an Excel model both to illustrate the discussion and also to help the directors learn more about Excel.

The team plans to discuss the costs of different types of capital, the process of calculating the weighted average cost of capital (WACC), the appropriate weights, how the WACC is used in the capital budgeting process, and how the corporate WACC is adjusted to reflect the risks of different projects.

Assume that you must prepare for the session. You must discuss the issues listed above, plus any others that you think are relevant for this session. For purposes of this case, assume that your analysis is conducted today.

Table 1. Data Used in the Analysis

Bond Data. Two dollar-denominated bonds are currently outstanding. Bond A has a 7.00 percent coupon, pays interest semi-annually, sells for $900.00, matures in 25 years, and can be called at a price of $1050 in 5 years. Bond B has a 10.00 percent semi-annual coupon, sells for $1125.00 also matures in 25 years, and can be called at a price of $1050 in 5 years. ABCs federal-plus-state tax rate is 35 percent. Assume that the analysis is conducted today. New bonds carrying the prevailing rate could be sold to institutional investors, and no bond flotation cost would be involved.

Preferred Stock Data. ABC has one issued of preferred stock outstanding, a perpetual and non-callable preferred that pays a $7.00 annual dividend, has a $100 par value, and currently sells for $110 per share. Investment bankers have indicated that ABC could sell additional shares with a dividend rate that would provide the same market yield, but such a sale would incur a flotation cost of 5.0%.

Common Equity Cost Data

CAPM ABCs estimated beta coefficient is 1.0. The risk-free rate is 3.0%, and the market risk premium is estimated to be 6.0%.

DCF ABCs stock sells for $21 per share. The company currently pays a dividend D(0) of $1.00, which is expected to grow 5.0% indefinitely.

Common Equity Flotation Costs

Amount of stock issued fee to all equity raised up to this amount (thousands)	Common % Floatation Costs	Net Price with $21 base
$0	0%	$21.00
$5,000	10%	$18.90
$10,000	25%	$15.75
$20,000	40%	$12.60

QUESTIONS

1. Based on the data in Table 1-a, what is a reasonable estimate of the companys cost of debt for use in the WACC calculation? Hint: Take an average of both bonds using the relevant rate

2. ABC also raises capital with preferred stock. Data on preferred stock are also provided in

Table 1. If ABC finances with preferred, what would its cost be for the WACC calculation?

3. Describe the rationale of the CAPM approach. What are the pros and cons of using the

CAPM for cost of capital purposes? Based on the Table 1 data, what is the cost of equity per the

CAPM?

4. Based on the Table 1 data, what is a reasonable estimate of ABCs DCF cost of equity?

What are the pros and cons of the DCF method? What are the principal sources for estimates

of the DCF growth rate, and what are the potential errors in that estimate?

5. Given data on the two cost of equity estimating techniques, what is your estimate of ABCs

cost of common equity, assuming all equity is raised as retained earnings?

6. ABCs target capital structure calls for 20% debt, 5% preferred stock, and 75% common

equity, all taken at market value. Assuming that new capital is raised in these percentages

and that all common equity is raised as retained earnings, what is ABCs WACC?

7.(a) Assuming that ABC will have $7.5 million of new retained earnings during the coming

year and that all capital is raised in accordance with the target capital structure, how large

could the capital budget be before the firm is required to sell new common stock to finance

the capital budget? (b) What would the WACC be for a $20 million project? Use the DCF approach for your new cost of equity. Weight your cost of equity between retained earnings and new stock issuance and use that to calculate your new WACC -