Integrative Case

Assume that you were recently hired as assistant to Jerry Lehman, financial VP of Coleman Technologies. Your first task is to estimate Colemans cost of capital. Lehman has provided you with the following data, which he believes is relevant to your task:

The firms marginal tax rate is 40%.

The current price of Colemans 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 firms 10%, $100 par value, quarterly dividend, perpetual preferred stock is $113.10. Coleman would incur flotation costs of $2 per share on a new issue.

Colemans common stock is currently selling at $50 per share. Its last dividend (D₀) was $4.19, and dividends are expected to grow at a constant rate of 5% in the foreseeable future. Colemans 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 four percentage-point risk premium.

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%.

Colemans target capital structure is 30% long-term debt, 10% preferred stock, and 60% common equity.

The firm is forecasting retained earnings of $300,000 for the coming year.

To structure the task somewhat, Lehman has asked you to answer the following questions:

What is the market interest rate on Colemans debt and its component cost of debt?

(1)What is the firms cost of preferred stock? (2) Colemans preferred stock is riskier to investors than its debt, yet the 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) What is Colemans estimated cost of retained earnings using the CAPM approach? (2) What is the estimated cost of retained earnings using the discounted cash flow (DCF) approach? (3) What is the bond-yield-plus-risk-premium estimate for Colemans cost of retained earnings? (4) What is your final estimate for r_s, Colemans cost of retained earnings?

What is Colemans cost for up to $300,000 of newly issued common stock, r_e1? What happens to the cost of equity if Coleman sells more than $300,000 of new common stock?

(1) What is Colemans overall, or weighted average, cost of capital (WACC) when retained earnings are used as the equity component? (2) What is the WACC after retained earnings have been exhausted and Coleman uses up to $300,000 of new common stock with a 15% flotation cost? (3) What is the WACC if more than $300,000 of new common equity is sold?