CASE

Berkshire Instruments

Al Hansen, the newly appointed vice

president of finance of Berkshire Instru$-$

ments, 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 $1.$

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 ot 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 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 $9\mathrm{.}3$ 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\mathrm{.}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 $(D_1).$ 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\mathrm{.}60$ per share and

$$2\mathrm{.}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 differentFigure $1$

BERKSHIRE INSTRUMENTS

Statement of Financlal Position

Decomber $31,2004$

Assets

Current assets:

Cash

Marketable securities

Accounts receivable

Less: Allowance for bad debts

Inventory.

Total current assets

Fixed Assets:

Plant and equipment, original cost

Less: Accumulated depreciation

Net plant and equipment

Total assets

$30,700,000$

$13\mathrm{.}200\mathrm{.}000$

Llabllities and Stockholders' Equity

Current liabilities:

Accounts payable.

Accrued expenses

Total current liabilities

Long$-$term financing:

Bonds payable.

Preferred stock.

Common stock Retained earnings