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Berkshire Instruments Al Hansen, the newly appointed vice president of finance of Berkshire Instruments, was eager to talk to his investment dealer about future financing for the firm. One of Al's first assignments was to determine the firm's cost of capital. In assessing the weights to use in computing the cost of capital, he examined the current balance sheet, presented in Figure 1. In their discussion, Al and his investment dealer determined that the current mix in the capital structure was very close to optimal and that Berkshire Instruments should continue with it in the future. (Our assumption here is that the current historical capital structure approximates the market value capital structure) Of some concern was the appropriate cost to assign to each of the elements in the capital structure. Al his Hansen requested that administrative assistant provide data on what the cost to issue debt and preferred stock had been in the past. The information is provided in Figure 2. When Al got the data, he felt he was making real progress toward determining the cost of capital for the firm. However, his investment dealer indicated that he was going about the process in an incorrect manner. The important issue is the current cost of funds, not the historical cost. The dealer suggested that a comparable firm in the industry, in terms of size and bond rating (BBB), Rollins Instruments, had issued bonds a year and a half ago for 9.3 percent interest at a $1,000 par value, and the bonds were currently selling for $890. The bonds had 20 years remaining to maturity. The dealer also observed that Rollings Instruments had just issued preferred shares at $60 per share, and the preferred stock paid an annual dividend of $4.80. In terms of cost of common equity, the dealer suggested that Al Hansen use the dividend valuation model as a first approach to determining cost of equity. Based on that approach, Al observed that earnings were $3 a share and that 40 percent would be paid out in dividends (D1). The current share price was $25. Dividends in the last four years had grown from 82 cents to the current value. The dealer indicated that the underwriting cost (flotation cost) on a preferred share issue would be $2.60 per share and $2.00 per share on common shares. Al Hansen further observed that his firm was in a 35 percent marginal tax bracket.