Berkshire Instruments

Al Hansen, the newly appointed vice president of finance of Berkshire Instruments, was eager to talk to his investment dealer about future financing for the firm. One of Als first assignments was to determine the firms 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 dealer 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. (Our assumption here is that the current historical capital structure approximates the market value capital structure) 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.

When Al got the data, he felt he was making real progress toward determining the cost of capital for the firm. However, his investment dealer 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 dealer suggested that a comparable firm in the industry, in terms of size and bond rating (BBB), 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 dealer also observed that Rollings Instruments had just issued preferred shares at $60 per share, and the preferred stock paid an annual dividend of $4.80.

In terms of cost of common equity, the dealer 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 share price was $25. Dividends in the last four years had grown from 82 cents to the current value.

The dealer indicated that the underwriting cost (flotation cost) on a preferred share issue would be $2.60 per share and $2.00 per share on common shares. 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 firms cost of capital. He was a little confused about computing the firms 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 dealer 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, 20XX
	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
	Capital Assets:
	Plant and equipment, original cost..............................	30,700,000
	Less: Accumulated amortization ............................	13,200,000
	Net plant and equipment............................................		17,500,000
	Total assets...................................................................		$25,900,000
	Liabilities and Shareholders 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
	Retained earnings		4,500,000
	Total common equity.............................................		10,800,000
	Total long-term financing...................................		18,000,000
	Total liabilities and shareholders equity.........................		$25,900,000

Figure 2 Cost of prior issues of debt and	Security	Year of Issue	Amount	Coupon Rate
preferred stock	Bond...............................................................................	20XX 12	$1,120,000	6.1%
	Bond...............................................................................	20 XX 8	3,000,000	13.8
	Bond...............................................................................	20 XX 2	2,000,000	8.3
	Preferred stock.................................................................	20 XX 7	600,000	12.0
	Preferred stock.................................................................	20 XX 4	480,000	7.9

Required

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). (Use the historical costs on the assumption they approximate market values) Common equity will represent 60 percent of financing throughout this case. Use Rollins instruments data to calculate the cost of preferred shares and debt. Recompute the weighted average cost of capital based on using new common shares in the capital structure. The weights remain the same, only common equity is now supplied by new common shares, 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. Assume the investment dealer also wishes to use the capital asset pricing model, as shown in Formula 11-4 in the text, to compute the cost (required return) on common shares. Assume Rf = 6 percent, is 1.25, and Rm is 13 percent. What is the value of Kj? How does this compare to the value of Ke computed in question 1?