Assignment Instructions

ReviewtheBerkshire Instruments Case Study

Completethe required activity 3ONLY MicrosoftWord.

Berkshire Instruments Al Hansen, the newly appointed vice president of finance of Berkshire Instruments, was eager to talk to his investment banker about future financing for 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 below. 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 appropriate cost to assign to each of the elements in the capital structure. Al Hansen requested that his administrative 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 below. When Al got the data, he felt he was making real progress toward determining the cost of capital for the firm. However, his investment banker indicated that he was going about the process in an incorrect manner. The important issue is the current cost of funds, not the historical cost. The banker suggested that a comparable 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 Rollings Instruments had just issued preferred stock at $60 per share, and the preferred stock paid an annual dividend of $4.80. In terms of cost of common equity, the banker suggested that Al Hansen use the dividend valuation model as a first approach to determining cost of equity. Based on that approach, Al observed that earnings were $3 a share and that 40 percent would be paid out in dividends (D1). The current stock price was $25. Dividends in the last four years had grown from 82 cents to the current value. The banker indicated that the under-writing cost (flotation 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. With all this information in hand, Al Hansen sat down to determine his firm's cost of capital. He was a little confused about computing the firm's cost of common equity. He knew there were two different formulas: One: 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. 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 300,000 2,300,000 Inventory .............................................................................. 5,500,000 Total current assets .......................................................... $ 8,400,000 Fixed Assets: Plant and equipment, original cost ....................................... 30,700,000 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 6,300,000 Common equity Retained earnings 4,500,000 Total common equity ....................................................... 10,800,000 Total long-term financing ............................................ 18,000,000 Total liabilities and stockholders' equity ................................. $25,900,000 Figure 2 Cost of prior issues of debt and Security Year of Issue Amount Coupon Rate 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 Activities: 1. Determine the weighted average cost of capital based on using retained earnings in the capital structure. Note: 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 above (it adds up to $18 million). Common equity will represent 60 percent of financing throughout this case. Use Rollins Instruments data to calculate the cost of preferred stock and debt. Show your work on your assignment document. 2. Recompute the weighted average cost of capital based on using new common stock in the capital structure. Note: The weights remain the same, only common equity is now supplied by new common stock, rather than by retained earnings. After how much new financing will this increase in the cost of capital take place? Determine this by dividing retained earnings by the percent of common equity in the capital structure. Show your work on your assignment document. 3. Write a 1 page summary that provides the following : A. Differentiate between the methods used in question 1 above and those used in question 2 above as it relates to the results. B. Provide your opinion on which method you would suggest and why, based on your findings. C. Add this summary below your answers to 1 and 2 above on your assignment file. 1. The weighted average cost of capital based on using retained earnings in the capital structure. Weighted Average cost of Capital Cost of bonds proportion of preferred stock is 1,080,000/18,000,000 = 6%. Interest rate= 9.3% Par value= $1,000 Cost of equity Price=$890 Earnings= $3 Maturity= 20 years Payout ratio=40% Marginal tax rate=35% D1= 40%3 Interest= 9.3%1000 = $1.20 = $93 Using trial and error method of substituting different rates or by using the RATE function in excel, the YTM as 10.65%. Cost of bonds= (1)+( )1/(+)1/2 = 10.65(10.35)+(1,000890)1/20(1000+890)1/2 = 6.92% Proportion of Debt - The total amount of debt is 6,120,000 and the total long term capital is 18,000,000. The proportion of debt is 6,120,000/18,000,000 = 34% Cost of preference shares Price=$60 Dividend=$4.8 Floatation cost=$2.6 = 0 = 4.8602.6 = 8.36% Proportion of Preferred Stock - The total amount of preferred stock is 1,080,000. The Price= $25 Floatation cost= $2.0 Growth= 1.20 = 0.82 X (1+g) ^4. This gives the value of g as 10% Cost of Equity = 1.20/25 + 10% = 14.8% The proportion of equity is 10,080,000/18,000,000=60%. The floatation cost are not used, since retained earnings are internally generated and not to be raised. WACC = Cost of Debt X proportion of debt + Cost of Preferred Stock X Proportion of preferred stock + Cost of equity X proportion of equity WACC = 6.92%X0.34 + 8.36% X 0.06 + 14.8% X 0.60 WACC = 11.73% 1. 2. Recompute WACC using new equity 2. 3. When new equity is to be raised, then there will be floatation cost. The net price will be $25-$2 the floatation cost = $23. 4. Cost of Equity = 1.20/23 + 10% = 15.2% 5. The new WACC is 6. WACC = 6.92%X0.34 + 8.36% X 0.06 + 15.2% X 0.60 7. WACC = 11.97% 8. Retained Earnings are $4,500,000 9. The proportion of equity in total capital structure is 60% 10. The increase in cost of capital will take after 4,500,000/60%=$7,500,000 of new financing. 11. 12. Write a 1 page summary that provides the following : 13. 14. A. Differentiate between the methods used in question 1 above and those used in question 2 15. above as it relates to the results. 16. 17. B. Provide your opinion on which method you would suggest and why, based on your findings. 18. 19. C. Add this summary below your answers to 1 and 2 above on your assignment file. 20. 21. 22. 23. 24. 25. 26. 27. 28. 29