Question 1

Assume that you are assisting financial VP, Jake Lewis of Spencer Technologies (ST). Your first task is to estimate STs cost of capital. Mr Lewis has provided you with the following data, which he believes is relevant to your task:

(1) The firms marginal tax rate is 40%.

(2) The current price of STs noncallable bond (12 % per annum coupon with 15 years remaining to maturity) is 1,153.72. ST 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 preferred stock (10%, 100 par value, perpetual quarterly dividend) is 113.10. ST would incur flotation costs of 2 per share on a new issue of preferred stock.

(4) STs 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 near future. STs beta is 1.2, the yield on Treasury bonds is 7%, and the market risk premium is estimated to be 6%. The firm uses a four percentage point risk premium under the bond-yield-plus-risk-premium approach.

(5) The floatation cost of issuing new common stock is 15% for value up to 300,000 and 25% for value above 300,000.

(6) STs target capital structure is 30% long-term debt, 10% preferred stock, and 60% common equity.

(7) The forecast retained earnings for the coming year are 300,000.

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

a. (1) What is the market interest rate on STs debt and its component cost of debt? (6 marks)

(2) What is the firms cost of preferred stock? (5 marks)

b. (1) What is STs estimated cost of retained earnings using the CAPM approach? (6 marks)

(2) What is STs overall, or weighted average, cost of capital (WACC) when retained earnings are used as the equity component? (8 marks)