Chapter 9 Cost of Capital

In-Class Project/Presentation

Eco Plastics Company

Since its inception, Eco Plastics Company has been revolutionizing plastic and trying to do its part to save the environment. Ecos founder, Marion Cosby, developed a biodegradable plastic that her company is marketing to manufacturing companies throughout the southeastern United States. After operating as a private company for 6 years, Eco went public in 2012 and is listed on the Nasdaq stock exchange.

As the chief financial officer of a young company with lots of investment opportunities, Ecos CFO closely monitors the firms cost of capital. The CFO keeps tabs on each of the individual costs of Ecos three main financing sources: long-term debt, preferred stock, and common stock. The target capital structure for Eco is given by the weights in the following table:

Source of capital	Weight
Long-term debt	30%
Preferred stock	20
Common stock equity	50
Total	100%

At the present time, Eco can raise debt by selling 20-year bonds with a $1,000 par value and a 10.5% annual coupon interest rate. Ecos corporate tax rate is 21%, and its bonds generally require an average discount of $45 per bond and flotation costs of $32 per bond when being sold. Ecos outstanding preferred stock pays a 9% dividend and has a $95-per-share par value. The cost of issuing and selling additional preferred stock is expected to be $7 per share. Because Eco is a young firm that requires lots of cash to grow, it does not currently pay a dividend to common stockholders. To track the cost of common stock, the CFO uses the capital asset pricing model (CAPM). The CFO and the firms investment advisors believe that the appropriate risk-free rate is 4% and that the markets expected return equals 13%. Using data from 2012 through 2018, Ecos CFO estimates the firms beta to be 1.3.

Although Ecos current target capital structure includes 20% preferred stock, the company is considering using debt financing to retire the outstanding preferred stock, thus shifting their target capital structure to 50% long-term debt and 50% common stock. If Eco shifts its capital mix from preferred stock to debt, its financial advisors expect its beta to increase to 1.5.

Instructions:

1. Calculate Ecos current after-tax cost of long-term debt.
2. Calculate Ecos current cost of preferred stock.
3. Calculate Ecos current cost of common stock.
4. Calculate Ecos current weighted average cost capital (WACC).
5. 1. Assuming that the debt financing costs do not change, what effect would a shift to a more highly leveraged capital structure consisting of 50% long-term debt, 0% preferred stock, and 50% common stock have on the risk premium for Ecos common stock? What would be Ecos new cost of common equity?
   2. What would be Ecos new weighted average cost of capital (WACC)?
   3. Which capital structurethe original one or this oneseems better? Why?
6. Create a presentation to Senior Management regarding the Current WACC vs proposed Target WACC. Make a recommendation of capital structure and why.
7. Complete Project Self Assessment