During the last few years, KMS Technologies has been too constrained by the high cost of capital to make many capital investments. Recently, though, capital costs have been declining, and the company has decided to look seriously at a major expansion program that had been proposed by the marketing department. Assume that you are a finance assistant to the financial vice-president. Your first task is to estimate KMSs cost of capital. The Vice-President has provided you with the following data, which he believes may be relevant to your task:

The firms tax rate is 40 percent. The current price of KMSs 12 percent coupon, semiannual payment, noncallable bonds with 15 years remaining to maturity is $1,153.72. KMS does not use short-term interest-bearing debt on a permanent basis. New bonds would be privately placed with no flotation cost.

The current price of the firms 10 percent, $100 par value, quarterly dividend, perpetual preferred stock is $113.10. KMS would incur flotation costs of $2.00 per share on a new issue.

KMSs common stock is currently selling at $50 per share. Its last dividend (D0) was $4.19, and dividends are expected to grow at a constant rate of 5 percent in the foreseeable future. KMSs beta is 1.2, the yield on T-bonds is 7 percent, and the market risk premium is estimated to be 6 percent. For the bond-yield-plus-risk-premium approach, the firm uses a 4-percentage point risk premium.

New common stock can be sold at a flotation cost of 15 percent. KMSs target capital structure is 30 percent long-term debt, 10 percent preferred stock, and 60 percent common equity.

The firm is forecasting retained earnings of $300,000 for the coming year.

To structure the task somewhat, the VP has asked you to answer the following question.

a) What sources of capital should be included when you estimate KMSs weighted average cost of capital?

b) What is the market interest rate on KMSs debt and its component cost of debt?

c) (i) What is the firms cost of preferred stock? (3 marks). (ii) KMSs preferred stock is riskier to investors than its debt, yet the preferreds yield to investors is lower than the yield to maturity on the debt. Does this suggest that you have made a mistake? (Hint: Think about taxes).

d) (i) What is KMSs estimated cost of common equity using the CAPM approach?

(ii) What is the estimated cost of common equity using the discounted cash flow (DCF) approach?

(iii) What is the final estimate for ks?

e) What is KMSs overall or WACC? Ignore floatation costs