Finance problem requirement2- recompute the weighted average cost based on new capital structure. require ment_3;- assume the investment banker wants to recalculate the cost of capital

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 Ar's first assignments was to determine the firm'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 1 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 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 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 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 $1,000 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 $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 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 $3 g share and that 40 percent would be paid out in dividends. (D.] current value The current stock price was $25. Dividends in the last four years had grown from 82 cents to the 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 Page 2 of 6 Q No 3(conta ) With all this information in hand, Al Hansen sat down to determine his firm's cost of capital He was a little confused about computing the firm's cost of common equity He knew there were two different 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 Figure 1 BERKSHIRE INSTRUMENTS Statement of Financial Position December 31, 2015 Assets Current assets Cash Marketable securities $400,000 Accounts receivable $2.600 000 200,000 Less Allowance for bad debts (300.000) 2,300,000 Inventory Total current assets 5.500.000 $8,400,000 Fixed Assets Plant and equipment, original cost 30,700,000 Less Accumulated depreciation (13 200 000) Net plant and equipment 17.500.000 Total assets $25.900.000 Liabilities and Stockholders' Equity Current liabilities Accounts payable $8.200,000 Accrued expenses 1 700.000 Total current liabilities 7,900,000 Long-term financing Bonds payable $6,120.000 Preferred stock 1,080,000 Common stock Common equity 6,300,000 Retained earnings 4 500 090 Total common equity 10.800,000 Total long-term financing 18 000.000 Total labilities and stockholders equity. $25 900 000 gure 2 out of prior issues Security Year of Issue Amount Coupon Rate debt and sforred stock Bond 2003 $1 120.000~ Bond 2007 3.000.000 138 Band 2013 2.000.000 83 Preferred stock 2008 600 000 120 Preferred stock 2011 480,000 79 arements Determine ifse weighted average cost of capital based on using retained earnings in the capital structure The percentage composition in the capital structure for bonds, preferred Neck and ity should be based on the current capital structure of long-term financing a pure 1 (# adido up to $18 million) Common equity will represent 60 ghout this case Use Rolling instruments data to calculate the cost of preferred stock and d