Instructions

You were recently hired as an assistant to the financial VP of Coleman Technologies and your first task is to estimate Coleman's cost of capital. The VP has provided you with the information below, which he believes is relevant to your task.

(1) The firm's marginal tax rate is 40%.

(2) The current price of Coleman's 15-year, 10% coupon (semiannual interest payments) bonds is $1,153.72. Coleman does not use short-term interest-bearing debt permanently. New bonds would be privately placed with no flotation costs.

(3) The current price of the firm's 9%, $100 par value preferred stock is $105. Coleman would incur flotation costs of 4.8% to issue new preferred stock.

(4) Coleman's common stock is currently selling at $50 per share. The company uses the average of the CAPM, DCF, and bond-yield-plus-risk premium calculations as its cost of equity. This average is 14%. Its last dividend (D₀) was $4.19, and dividends are expected to grow at a constant rate of 5% in the foreseeable future. Coleman's beta is 1.2, the yield on Treasury bonds is 7%, and the market risk premium is estimated to be 6%. For the bond-yield-plus-risk-premium approach, the firm uses a 4%-point risk premium.

(5) Up to $300,000 of new common stock can be sold at a flotation cost of 15%. Above $300,000, the flotation cost would rise to 25%.

(6) Coleman's target capital structure is 30% debt, 10% preferred stock, and 60% common equity.

(7) The firm forecasts it will retain earnings equal to $300,000 in the coming year.

After reviewing this information, the VP has asked you to do the following.

1. What is Coleman's overall, or weighted average, cost of capital (WACC) when retained earnings are used as the equity component? You must show your work as well as explain why.
2. Should the component costs be figured on a before-tax or an after-tax basis? Explain.
3. What is the WACC if more than $300,000 of new common equity is sold?
4. Use the DCF method to calculate the cost of the new common stock. You must show your work as well as explain your answer.

*** Explain in words why the new common stock has a higher percentage cost than the cost of retained earnings.