Determine the weighted average cost of capital

Can you help me with the question. It is on the document i upload

thanks

CASE Berkshire AI 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 AI's first assignments was to determine the firn1'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 I. In their discussion, AI and his investment bal1kcr determined that the current mix in the capital structure was ver:-' 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. AI Hansen requested that his administrative assistant provide data on what the cost ot issue debt and preferred stock had been in the past. T11einformation is provided in Figure 2. When AI 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. T11e banker suggested that a comparable firm in the industr:-', in terms of size and bond rating Instruments (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. 111ebanker 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 AI Hansen use the dividend valuation model as a first approach to determining cost of equity. Based on that approach, AI observed that earnings were $3 a share and that 40 percent would be paid out in dividends (Dl). The current stock price was $25. Dividends in the last four years had grown from 82 cents to the current value. 111e banker indicated that the underwriting cost (flotation cost) on a preferred stock issue would be $2.60 per share and $2.00 per share on common stock. AI Hansen further observed that his firm was in a 35 percent marginal tax bracket. With all this information in hand, AI Hansen sat down to determine his firm's cost of capital. He was a little col1fused about computing the firn1 ' s cost of common equity. He knew there were two different ~ 40 Case 10 Figure 1 BERKSHIREINSTRUMENTS Statement of Financial Position December 31, 1999 Assets Cwrent assets: Accow1ls Marketable Cash Less: Allowance receivable securities for bad $ debts 400,000 200,000 $ 2,600,000 300.000 Fixed Inventory Total Assets: Total Net Plant Less: assetsplant current and Liabilities assets Accumulatedequipment, and 00 00.000..0.0.0 equipment and original depreciation Stockholders' 00.0.0 cost 0..0...0 2,300,000 5.500.000 $ 8,400,000 30,700,000 13.200.000 Equity 17.500.000 $25.900.000 Current Long-tt:nn Accrued Accounts Total liabilities: curret1lIiabilities lu\\ancing: expenses payable 0.0 $ 6,200,000 1.700.000 7,9()(),000 payable Total Figure 2 C(ISt of prior issues of debt and preferred stock . Total Totallong-tenn liabilities col\\Unon . eqUltv .Conunon d } ame e R t . $ 6,120,000 1,080,000 6,300,000 4.500.000 10,800,000 18.000.000 $25.900.000 stock ennungs Col\\Unon Prelerred Bonds and stockl\\olders' equity Imancing 0 Security equity Year of Issue Amount Yield 6.1% stock 3,000,000 2,000,000 8.3 1992 Prelen-ed $1,120,000 1997 stock 1987 1991 Prelen-ed B011d Bond 600,000 12.0 1995 480,000 7.9 13.8 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 41 Instruments Required 2 3 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 I (it adds up to $18 million). Common equity will represent 60 percent of financing throughout this case. 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). 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 ~,. = 6 percent, 13is 1.25, a11d is 13 percent. What is the value of ~? How does t11iscompare to K., the value of K" computed in question 1