Berkshire Instruments Al Hansen, the newly appointed vice (Baa), Rollins Instruments, had issued bonds president of finance of Berkshire Instrua year and a half ago for 9.3 percent interest ments, was eager to talk to his investment at a $1,000 par value, and the bonds were banker about future financing for the firm. currently selling for $890. The bonds had 20 One of Al's first assignments was to years remaining to maturity. The banker also determine the firm's cost of capital. In observed that Rollings Instruments had just assessing the weights to use in computing issued preferred stock at $60 per share, and the cost of capital, he examined the current the preferred stock paid an annual dividend balance sheet, presented in Figure 1 . of $4.80. In their discussion, Al and his investment In terms of cost of common equity, the banker determined that the current mix in banker suggested that Al Hansen use the the capital structure was very close to dividend valuation model as a first approach optimal and that Berkshire Instruments to determining cost of equity. Based on that should continue with it in the future. Of approach, Al observed that earnings were $3 some concern was the appropriate cost to a share and that 40 percent would be paid assign to each of the elements in the capital out in dividends (D1). The current stock structure. Al Hansen requested that his price was $25. Dividends in the last four administrative assistant provide data on years had grown from 82 cents to the current what the cost ot issue debt and preferred value. stock had been in the past. The information The banker indicated that the underis provided in Figure 2. writing cost (flotation cost) on a preferred When Al got the data, he felt he was stock issue would be $2.60 per share and making real progress toward determining the $2.00 per share on common stock. Al cost of capital for the firm. However, his Hansen further observed that his firm was in investment banker indicated that he was a 35 percent marginal tax bracket. going about the process in an incorrect With all this information in hand, Al manner. The important issue is the current Hansen sat down to determine his firm's cost of funds, not the historical cost. The cost of capital. He was a little confused banker suggested that a comparable firm in about computing the firm's cost of common the industry, in terms of size and bond rating equity. He knew there were two different Figure 1 Figure 2 Cost of prior issues of debt and preferred stock 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. Berkshire Instruments 49 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. 2. Recompute the weighted average cost of capital based on using new common stock in the capital structure. 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 (this is a slight variation from the formula in the book, due to an added dimension in the case). 3. Assume the investment banker also wishes to use the capital asset pricing model, as shown in Formula 11.5 in the text, to compute the cost (required return) on common stock. Assume Rf=6 percent, B is 1.25 , and Km is 13 percent. What is the value of Kj ? How does this compare to the value of Ke computed in question 1 ? The Cost of Capital case is found under Cases within Modules. Please read these instructions. 1. Calculate the WACC for question 1 exactly as stated on page 3 of the case. 2. Recompute the WACC based on using new common stock in the capital structure. The weights remain the same, only common equity is now supplied by new common stock, rather than supplied by retained earnings. Omit the rest of question 2. 3. Use the Capital Asset Pricing Model (CAPM) to calculate the cost of equity. The values for the CAPM variables are provided in question 3 of the case. How does this cost of equity using CAPM compare to the cost of equity from question 1
