Eco Plastics Company (This p roblem is taken from principles of managerial finance )

Since its inception, Eco Plastics Company has been revolutionizing plastic and trying to do its part to save the environment. Eco's 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 six years, Eco went public in 2009 and is listed on the NASDAQ stock exchange. As the chief financial officer of a young company with lo ts of investment opportunities, Eco's CFO closely monitors the firm's cost of capital. The CFO keeps tabs on each of the individual costs of Eco's three main fin ancing sources: long - term debt, preferred stock, an d common stock. The target capita l 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 sell ing 20 - year bonds with a $1,000 par value and a 10.5% annual coupon interest rate. Eco' s corporate tax rate is 40 % . Eco's outsta nding preferred stock pays a 9% dividend and has a $95 - per - share par value. Because Eco is a young firm that requires lots of cash to grow it does not cur rently pay a dividend to common stock holders. To track the cost of common stock the CFO uses the capital asset pricing model (CAPM). The CFO and the firm's inves tment advisors believe that the appropriate risk - free rate is 4% a nd that the market' s expected return equals 13%. Using data from 2009 through 2012, Eco's CFO estimates the firm's beta to be 1.3. Although Eco's current target capital structur e includes 20% preferred stock, the company is considering using debt financin g to r etire the outstanding preferred stock, thus shifting their target capital structur e to 50% long - term debt and 50% common stock. If Eco shifts its capital mix from preferr ed stock to debt, its financial advisors expect its beta to increase to 1.5.

a. Calculate Eco's current after - tax cost of long - term debt.

b. Calculate Eco's current cost of preferred stock.

c. Calculate Eco's current cost of common stock.

d. Calculate Eco's current weighted average cost capital.

e. (1) Assuming that the debt financin g 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 Eco's common stock? What would be Eco's new cost of common equity? (2) What would be Eco's new weighted average cost of capital? (3) Which capital structure the original one or this one seems better? Why?