Integrative Case $4$ Enviro Plastics Company

Since its inception, Enviro Plastics Company has been revolutionizing plastic and trying to do its part to save the environment. Enviro$$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, Enviro went public in $2015$ and is listed on the Nasdaq stock exchange.

As the chief financial officer of a young company with lots of investment opportunities, Enviro$$s CFO closely monitors the firm$$s cost of capital. The CFO keeps tabs on each of the individual costs of Enviro$$s three main financing sources: long$-$term debt, preferred stock, and common stock. The target capital structure for Enviro 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, Enviro can raise debt by selling $20-$year bonds with a $$1,000$ par value and a $10\mathrm{.}5\%$ annual coupon interest rate. Enviro$$s corporate tax rate is $21\%,$ and its bonds generally require an average discount of $$45$ per bond and flotation costs of $$32$ per bond when being sold. Enviro$$s outstanding preferred stock pays a $9\%$ dividend and has a $$95-$per$-$share par value. The cost of issuing and selling additional preferred stock is expected to be $$7$ per share. Because Enviro is a young firm that requires lots of cash to grow, it does not currently pay a dividend to common stockholders. To track the cost of common stock, the CFO uses the capital asset pricing model $($CAPM$).$ The CFO and the firm$$s investment advisors believe that the appropriate risk$-$free rate is $4\%$ and that the market$$s expected return equals $13\%.$ Using data from $2015$ through $2021,$ Enviro$$s CFO estimates the firm$$s beta to be $1\mathrm{.}3.$

Although Enviro$$s current target capital structure includes $20\%$ preferred stock, the company is considering using debt financing to retire the outstanding preferred stock, thus shifting their target capital structure to $50\%$ long$-$term debt and $50\%$ common stock. If Enviro shifts its capital mix from preferred stock to debt, its financial advisors expect its beta to increase to $1\mathrm{.}5.$

To Do

Calculate Enviro$$s current after$-$tax cost of long$-$term debt.

Calculate Enviro$$s current cost of preferred stock.

Calculate Enviro$$s current cost of common stock.

Calculate Enviro$$s current weighted average cost capital $($WACC$).$

$(1)$ Assuming that the cost of debt financing does 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 Enviro$$s common stock?

$(2)$ What would be Enviro$$s new cost of common equity?

$(3)$ What would be Enviro$$s new weighted average cost of capital $($WACC$)?$

$(4)$ Which capital structure$$the original one or this one$$seems better? Why?