Al Hansen, the newly appointed vice presiden t of fin an ce of Berksh ire Instruments, was eager to talk to his investment banker about future financingfor the firm. One of Al's first assignments was to determine the firm's cost of capital.In assessing the weights to use in computing the cost of capital, he examined the current balance sheet, presented in Figure 1.

In their discussion, Al and his investment banker determined that the current mix in the capital structure was very close to optimal and that Berkshire Instruments should continue with it in the future. Of some concern was the appropriat e cost t o assign t o each of the elem en t s in t he capit al st ructure. Al Hansen requ est ed t h at h is adm in ist rative assistant provide data on what the cost to issue debt and preferred stock had been in the past. The information is provided in Figure 2.

When Al got the data, he felt he was m akin g real progress t oward det erm ining the cost of capital for the firm. However, his investment banker indicated that he was goin g abou t t h e process in an in correct manner. The important issue is the current cost of funds, not the historical cost. The

ban ker su ggest ed t h at a com parable firm in the industry, in terms of size and bond rating (Baa), Rollins Instruments, had issued bonds a year and a half ago for 9.3 percent interest at a $1,000 par value, and the bonds were currently selling for $890. The bonds had 20 years remaining to maturity. The banker also observed that Rollins Instruments had just issued preferred st ock at $60 per sh are, an d the preferred st ock paid an an n u al dividend of $4.80.

In terms of cost of common equity, the banker suggested that Al Hansen use the dividen d valu at ion m odel as a first approach t o det erm in in g cost of equity. Based on t h at approach , Al observed that earnings were $3 a share and that 40 percen t wou ld be paid ou t in dividen ds (D1). Th e cu rren t st ock price was $25. Dividends in the last four years had grown from 82 cents to the current value.

The banker indicated that the under- writ in g cost (flot at ion cost ) on a preferred stock issue would be $2.60 per share and $2.00 per share on common stock. Al Hansen further observed that his firm was in a 35 percent marginal tax bracket.

CASE STUDY 3

Berkshire Instruments

Figure 1

BERKSHIRE INSTRUMENTS Statement of Financial Position December 31, 2015

With all this information in hand, Al Hansen sat down to determine his firm'scost of capital. He was a little confused about computing the firm's cost of commonequity. He knew there were two different formulas: one for the cost of retained earnings and one for the cost of new common stock. His investment banker suggested that he follow the normally accepted approach used in determining the marginal cost of capital. First, determine the cost of capital for as large a capital structure as current retained earnings will support; then, determine the cost of capital based on exclusively using new common stock.

BADM 530 Case Study 3 Berkshire Instruments.pdf (page 2 of FO Q Sear Figure 1 BERKSHIRE INSTRUMENTS Statement of Financial Position December 31, 2015 Assets Current assets: Cash........ $ 400,000 Marketable securities...... ..... 200,000 Accounts receivable..........................." $ 2,600,000 Less: Allowance for bad debts 300,090 2,300,000 Inventory..... 5,500,000 Total current assets ..... $ 8,400,000 Fixed Assets: Plant and equipment, original cost............... 30,700,090 Less: Accumulated depreciation .................... 13,200,000 Net plant and equipment... 17,500,000 Total assets ..... $25,900,000 Liabilities and Stockholders' Equity Current liabilities: ..... Accounts payable ........ $ 6,200,000 Accrued expenses......... 1,700,000 Total current liabilities .......... 7,900,000 Long-term financing: Bonds payable...... $ 6,120,000 Preferred stock ..... 1,080,000 Common stock Retained earnings Common equity 6,300,000 4,500,000 Total common equity ............. 10,800,000 Total long-term financing................................... 18,000,000 Total liabilities and stockholders' equity ........................ $25,900,000 W W 100 -II 8 9 O27% [4] Wed 9:41 PM Q E A canvas awil adil BADM 530 Case Study 3 Berkshire Instruments.pdf (page 3 of 3) Q Search nl... + Berkshire Instruments Figure 2 Cost of prior issues Security Year of Issue Amount Coupon Rate of debt and preferred stock Bond.. 2003 $1,120,000 6.1% Bond. 2007 3,000,000 13.8 Bond .......... 2013 2,000,000 8.3 Preferred stock 2008 600,000 12.0 Preferred stock 2011 480,000 7.9 Required 1. Determine the weighted average cost of capital based on using retained earnings in the capital structure. The percentage composition in the capital structure for bonds, preferred stock, and common equity should be based on the current capital structure of long-term financing as shown in Figure 1 (it adds up to $18 million). Common equity will represent 60 percent of financing throughout this case. Use Rollins instruments data to Icalculate the cost of preferred stock and debt. 2. Recompute the weighted average cost of capital based on using new common stock in the capital structure. The weights remain now supplied by new common