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Yorkman Technologies is considering a major expansion program that has been proposed by the companys information technology group. Before proceeding with the expansion, the company must estimate its cost of capital. Assume that you are an assistant to Troy Aikman, the financial vice president. Your first task is to estimate Yorkmans cost of capital. Aikman has provided you with the following data, which he believes may be relevant to your task.

(1) The firms tax rate is 40%.

(2) The current price of Yorkmans 12% coupon, semiannual payment, noncallable bonds with 15 years remaining to maturity is $1,153.72. Yorkman does not use short-term interest-bearing debt on a permanent basis. New bonds would be privately placed with no flotation cost.

(3) The current price of the firms 10%, $100.00 par value, quarterly dividend, perpetual preferred stock is $111.10.

(4) Yorkmans common stock is currently selling for $50.00 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. Yorkmans 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-riskpremium approach, the firm uses a risk premium of 4%.

(5) Yorkmans target capital structure is 30% debt, 10% preferred stock, and 60% common equity. To structure the task somewhat, Aikman has asked you to answer the following questions.

a. (1) What sources of capital should be included when you estimate Yorkmans 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 Yorkmans debt and its component cost of debt?

c. (1) What is the firms cost of preferred stock?

(2) Yorkmans preferred stock is riskier to investors than its debt, yet the preferreds 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.)

d. (1) Why is there a cost associated with retained earnings?

(2) What is Yorkmans 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 Yorkmans 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) Yorkman estimates that if it issues new common stock, the flotation cost will be 15%. Yorkman 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 Yorkmans overall, or weighted average, cost of capital (WACC)? Ignore flotation costs.

k. What factors influence Yorkmans composite WACC?

l. Should the company use the composite WACC as the hurdle rate for each of its projects? Explain