Integrated Case Coleman Technologies Inc. 10-22 COST OF CAPITAL Coleman Technologies is considering a major expansion program that has been proposed by the company's information technology group. Before proceeding with the expansion, the company must estimate its cost of capital. Suppose you are an assistant to Jerry Lehman, the financial vice president. Your first task is to estimate Coleman's cost of capital. Lehman has provided you with the following data, which he believes may be relevant to your task. The firm's tax rate is 40%. The current price of Coleman's 12% coupon, semiannual payment, noncallable bonds with 15 years remaining to maturity, is $1,153.72. Coleman 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 firm's 10%, $100.00 par value, quarterly dividend, perpetual preferred stock is $111.10. Coleman's common stock is currently selling for $50.00 per share. Its last dividend (D) was $4.19, and dividends are expected to grow at a constant annual rate of 5% in the foreseeable future. Coleman's beta is 1.2, the yield on T-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 risk premium of 4%. a. C. Coleman's target capital structure is 30% debt, 10% preferred stock, and 60% common equity. To structure the task somewhat, Lehman has asked you to answer the following questions, 1. What sources of capital should be included when you estimate Coleman's WACC? 2. Should the component costs be figured on a before-tax or an after-tax basis? 3. Should the costs be historical (embedded) costs or new (marginal) costs? b. What is the market interest rate on Coleman's debt and its component cost of debt? 1. What is the firm's cost of preferred stock? 2. Coleman's preferred stock is riskier to investors than its debt, yet the preferred's 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.) 1. Why is there a cost associated with retained earnings? 2. What is Coleman's estimated cost of common equity using the CAPM approach? e. What is the estimated cost of common equity using the DCF approach? f. What is the bond-yield-plus-risk-premium estimate for Coleman's cost of common equity? g. What is your final estimate for rs ? h. Explain in words why new common stock has a higher cost than retained earnings. d. i. 1. What are two approaches that can be used to adjust for flotation costs? 2. Coleman estimates that if it issues new common stock, the flotation cost will be 15%. Coleman d. 1. Why is there a cost associated with retained earnings? 2. What is Coleman's estimated cost of common equity using the CAPM approach? e. What is the estimated cost of common equity using the DCF approach? f. What is the bond-yield-plus-risk-premium estimate for Coleman's cost of common equity? g. What is your final estimate for rs ? h. Explain in words why new common stock has a higher cost than retained earnings. i. 1. What are two approaches that can be used to adjust for flotation costs? 2. Coleman estimates that if it issues new common stock, the flotation cost will be 15%. Coleman incorporates the flotation costs into the DCF approach. What is the estimated cost of newly issued common stock, considering the flotation cost? j. What is Coleman's overall, or weighted average cost of capital (WACC)? Ignore flotation costs. k. What factors influence Coleman's composite WACC? 1. Should the company use the composite WACC as the hurdle rate for each of its projects? Explain. Taking a Closer Look Calculating 3M's Cost of Capital Use online resources to work on this chapter's questions. Please note that website information changes over Taking a Closer Look Calculating 3M's Cost of Capital Use online resources to work on this chapter's questions. Please note that website information changes over time, and these changes may limit your ability to answer some of these questions. In this chapter, we described how to estimate a company's WACC, which is the weighted average of its costs of debt, preferred stock, and common equity. Most of the data we need to do this can be found from various data sources on the Internet. Here we walk through the steps used to calculate Minnesota Mining & Manufacturing's (MMM) WACC. Discussion Questions 1. As a first step, we need to estimate what percentage of MMM's capital comes from debt, preferred stock, and common equity. This information can be found on the firm's latest annual balance sheet. (As of year end 2014, MMM had no preferred stock.) Total debt includes all interest-bearing debt and is the sum of short-term debt and long-term debt. a. Recall that the weights used in the WACC are based on the company's target capital structure. If we assume that the company wants to maintain the same mix of capital that it currently has on its balance sheet, what weights should you use to estimate the WACC for MMM? b. Find MMM's market capitalization, which is the market value of its common equity. Using the sum of its short-term debt and long-term debt from the balance sheet (we assume that the market value of its debt equals its book value) and its market capitalization, recalculate the firm's debt and common equity weights to be used in the WACC equation. These weights are approximations of market value b. Find MMM's market capitalization, which is the market value of its common equity. Using the sum of its short-term debt and long-term debt from the balance sheet (we assume that the market value of its debt equals its book value) and its market capitalization, recalculate the firm's debt and common equity weights to be used in the WACC equation. These weights are approximations of market-value weights. Be sure not to include accruals in the debt calculation. 2. Once again we can use the CAPM to estimate MMM's cost of equity. From the Internet, you can find a number of different sources for estimates of beta-select the measure that you think is best, and combine this with your estimates of the risk-free rate and the market risk premium to obtain an estimate of its cost of equity. (See the Taking a Closer Look problem in Chapter 8 for more details.) What is your estimate for MMM's cost of equity? Why might it not make much sense to use the DCF approach to estimate MMM's cost of equity? 3. Next, we need to calculate MMM's cost of debt. We can use different approaches to estimate it. One approach is to take the company's interest expense and divide it by total debt (which is the sum of short- term debt and long-term debt). This approach only works if the historical cost of debt equals the yield to maturity in today's market (i.e., if MMM's outstanding bonds are trading at close to par). This approach may produce misleading estimates in years in which MMM issues a significant amount of new debt. For example, if a company issues a great deal of debt at the end of the year, the full amount of debt will appear on the year-end balance sheet, yet we still may not see a sharp increase in annual interest expense because the debt was outstanding for only a small portion of the entire year. When this situation occurs, the estimated cost of debt will likely understate the true cost of debt. Another approach is to try to find this number in the notes to the company's annual report by accessing the company's home page and its Investor Relations section. Alternatively, you can go to other external sources, such as bondsonline.com, maturity in today's market (i.e., if MMM's outstanding bonds are trading at close to par). This approach may produce misleading estimates in years in which MMM issues a significant amount of new debt. For example, if a company issues a great deal of debt at the end of the year, the full amount of debt will appear on the year-end balance sheet, yet we still may not see a sharp increase in annual interest expense because the debt was outstanding for only a small portion of the entire year. When this situation occurs, the estimated cost of debt will likely understate the true cost of debt. Another approach is to try to find this number in the notes to the company's annual report by accessing the company's home page and its Investor Relations section. Alternatively, you can go to other external sources, such as bondsonline.com, for corporate bond spreads, which can be used to find estimates of the cost of debt. Finally, you can also go to Morningstar.com, which will provide yield to maturity information on the firm's various bond issues. A longer-term issue's YTM could provide an estimate of the firm's current cost of debt to be used in the WACC calculation. Remember that you need the after-tax cost of debt to calculate a firm's WACC, so you will need MMM's tax rate (which has averaged around 30% in recent years). What is your estimate of MMM's after-tax cost of debt? a. What is your estimate of MMM's WACC using the book-value weights calculated in question la? b. What is your estimate of MMM's WACC using the market-value weights calculated in question 1b2 c. Explain the difference between the two WACC estimates. Which estimate do you prefer? Explain your answer d. How confident are you in the estimate chosen in part c? Explain your answer. 4