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Berkshire Instruments Al 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 Al's first assignments was to determine he firm's cost of capital. In assessing the weights to use in computing the costof capital he examined the current balance sheet, 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 9.3 percent interest at a S1,000 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 S60 per share, and the preferred stock paid an annual dividend of $4.80. presented in Figure l 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 to issue debt and preferred stock had been in the past. The information is provided in 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 S3 a share and that 40 percent would be paid out in dividends D). The current stock price was S25 Dividends in the last four years had grown from 82 cents to the current value 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 banker indicated that the under- writing cost (flotation cost) on a preferred stock issue would be $2.60 per share and $2.00 per share on common stock. Al Hansen further observed that his firm was in a 35 percent marginal tax bracket